The Application Of Fundamental Valuation Principles To Property

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The Application Of Fundamental Valuation Principles To Property Powered By Docstoc
					      The Application Of Fundamental Valuation
Principles To Property/Casualty Insurance Companies

                 Derek A. Jones, FCAS
               Joy A. Schwartzman, FCAS
              Valuation Principles

1.    The value of any business has two
      determining factors:
     i.  The future earnings stream generated
         by a company’s assets and liabilities.
     ii. The risk (or “volatility”) of the stream of
         earnings.
          This risk is reflected in the cost to the
          entity of acquiring capital, measured by
          the investors’ required rate of return
          (“hurdle rate”).
                          2
           Valuation Principles

2.   For a given level of future risk, the
     greater the PV of expected profits the
     greater the value.

3.   For a given level of future profitability, the
     greater the volatility (i.e., the higher the
     hurdle rate), the lower the value of the
     business.


                        3
           Valuation Principles
4.   A company has value in excess of its invested
     capital only when future returns are in excess of
     the hurdle rate.

5.   When a company is expected to produce an
     earnings stream that yields a return on invested
     capital that is less than the hurdle rate, the
     economic value of the required capital is less
     than its face value.

     In this case, the logical action would be to
     liquidate assets.
                         4
                    Valuation
Financial Professionals
Value = PV of Future Cash Flows
       Where cash flows represent
       dividendable earnings or earnings
       that can be released to investors

Actuaries
Value = ANW + PV of Future Earnings – COC
       Where ANW = adjusted net worth
       PV = Present Value
       COC = Cost of Capital


                            5
          Valuation Literature
1.   Discounted Cash Flows “DCF”
     A DCF model discounts free cash flows at
     the hurdle rate to determine value
2.   Economic Value Added “EVA”
     An EVA model defines
      Value =   Initial capital invested
                             +
                PV of “Excess returns”
                      6
      To Value An Entity…
   Financial Professionals Commonly use
    DCF Methodology

   Actuaries commonly use EVA
    Methodology


   When the underlying assumptions are
    common, the two methodologies yield
    identical results.
                   7
 What are these assumptions…

I.     Starting capital

II.    After-tax annual operating income

III.   Capital required at the beginning of each
       year to support operations

IV.    The hurdle rate
                          8
      Discounted Cash Flow Value

   Represents the PV of distributable
    earnings
   PV is based on hurdle rate, which is
    the return required by investors to
    provide capital



                     9
      Discounted Cash Flow Value

   Distributable earnings are based on
    after tax operating earnings of the entity
    plus any additional capital releases,
    minus any capital infusions

   Capital releases or infusions are a
    function of the capital needed to
    support the following years’ operations.
                      10
     Discounted Cash Flow Value

   Company’s initial capital is reflected only
    to the extent:

    a) it is released
       or
    b) it generates operating earnings

                     11
    Discounted Cash Flow Value

   Distributable earnings often projected
    in two components

    a) Value of an explicit forecast period
       – say 5 to 10 years

    b) Value associated with the entity
       after the explicit forecast period:
       the “Terminal Value”

                    12
       Discounted Cash Flow Value
   Value of explicit forecast period based on
    detailed annual earnings projections reflecting
     a) Revenues (premiums)
     b) Loss and Loss Adjustment Expenses
     c) Acquisition and Operating Expenses
     d) Investment Income
     e) Taxes
     f) Assets
     g) Liabilities
     h) Initial Capital to Support Operations
     i) Capital Infusions or Releases to Support
        Operations
                         13
      Discounted Cash Flow Value
   Terminal Value (“TV”) represents the
    value of the company associated with
    earnings after the explicit earnings
    period, discounted back to the valuation
    date.

   TV often calculated from earnings from
    last year of explicit forecast period,
    multiplied by a P/E factor.
                     14
      Discounted Cash Flow Value
   The P/E factor can be based on sale prices of
    recent insurance company transactions.

   Any P/E factor can be mathematically distilled
    to an implicit earnings growth rate (“g”) and
    hurdle rate (“h”)

   P/E =

   For example, with a growth rate of 5% and
    hurdle rate of 15%, P/E =
                        15
     Discounted Cash Flow Value
In summary inputs to compute DCF value are…

 Starting capital of the entity less initial capital
  required to determine free cash flow (at T=0)
 Annual after-tax operating earnings
 Marginal capital required at the start of each
  earnings period
 The hurdle rate

DCF Value = Free Capital +

                        16
       Economic Value Added
   Value    = Initial Capital
             + PV “Excess Returns”:

       Where excess returns
       = after-tax operating earnings
       – (hurdle rate x capital invested)

   Therefore, Value EXCEEDS initial capital only
    if earnings EXCEED investors’ required return
    (the “hurdle rate”)
                       17
       For Valuing an Insurance
             Company …
   Value = ANW + PVFE – COC
      “ANW” represents Initial Capital

      “PVFE – COC” represents excess
      returns

      PVFE = PV [after tax operating
      earnings]

      COC = PV [each period starting
      capital x hurdle rate]
                     18
      For Valuing an Insurance
            Company…

   Initial Capital represented by
    Statutory capital and surplus, with
    certain modifications




                   19
          For Valuing an Insurance
                Company…
   Statutory earnings form the basis of
    after-tax operating earnings. Earnings
    include:
     i.     Runoff of existing balance sheet
            assets and liabilities
     ii.    Earnings contributions from renewal
            business
     iii.   Earnings contributions from new
            business      20
    For Valuing an Insurance
          Company…
   Cost of capital is computed as:
    PV (hurdle rate x the starting
    capital in each period)

   PV of statutory earnings and cost
    of capital computed using the
    hurdle rate

                 21
In Summary Inputs to Compute EVA
Value and to Value an Insurance
Company are …
   Starting capital of the entity

   Required capital at the start of each
    earnings period

   Annual after-tax operating earnings

   The hurdle rate
                      22
                 Valuation Results
Scenario 1A
Initial Capital = $100
Hurdle Rate 15%
Total Earnings = Hurdle Rate



                          Table 1
                     Valuation Results
                 Earnings Growth Rate = 0%

                         10 Year     Terminal
        Model        Forecast Period  Value     Total
     DCF                    75         25       100
     EVA                   100          0       100
                               23
                 Valuation Results
Scenario 1B
Initial Capital = $100
Hurdle Rate 15%
Total Earnings = Hurdle Rate

                          Table 2
                     Valuation Results
                 Earnings Growth Rate = 3%

                        10 Year          Terminal
       Model        Forecast Period       Value     Total

    DCF                        67          33       100
    EVA                    100              0       100
                                    24
                 Valuation Results
Scenario 2A
Initial Capital = $100
Hurdle Rate 15%
Total Earnings > Hurdle Rate

                          Table 3
                     Valuation Results
                 Earnings Growth Rate = 0%

                        10 Year          Terminal
       Model        Forecast Period       Value     Total

    DCF                        80          26       106
    EVA                    105              1       106
                                    25
                 Valuation Results
Scenario 2B
Initial Capital = $100
Hurdle Rate 15%
Total Earnings > Hurdle Rate

                          Table 4
                     Valuation Results
                 Earnings Growth Rate = 3%

                        10 Year          Terminal
       Model        Forecast Period       Value     Total

    DCF                        74          36       110
    EVA                    107              3       110
                                    26
                 Valuation Results
Scenario 3A
Initial Capital = $100
Hurdle Rate 15%
Total Earnings < Hurdle Rate

                          Table 5
                     Valuation Results
                 Earnings Growth Rate = 0%

                        10 Year          Terminal
       Model        Forecast Period       Value     Total

    DCF                        70          23       93
    EVA                        95          (2)      93
                                    27
                 Valuation Results
Scenario 3B
Initial Capital = $100
Hurdle Rate 15%
Total Earnings < Hurdle Rate

                          Table 6
                     Valuation Results
                 Earnings Growth Rate = 3%

                        10 Year          Terminal
       Model        Forecast Period       Value     Total

    DCF                        60          30       90
    EVA                        93          (3)      90
                                    28
      Practical Considerations

   Accounting Standard

   How to Modify Initial Capital & Surplus

   Composition of Free Cash Flow (DCF)
    or Increments of Added Value (EVA)

   Hurdle rate
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        Accounting Standard

 ASOP 19: based on “regulatory
  earnings”
 Constraints on dividends to equity
  owners:
    – Accumulated earnings
    – Minimum capital and surplus
      requirements
   SAP is current starting point
                     30
     Accounting Developments

   Codification of SAP (2001)
    – Deferred taxes
    – Premium deficiency reserve
   Fair Value Accounting




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    Balance Sheet Adjustments

 Loss reserve adequacy
 Market value of assets
 Inclusion of non-admitted assets
 Accounting goodwill
 Statutory provision for reinsurance
 Tax issues


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       Estimating Net Income

   After-tax operating earnings
    – Runoff of existing balance sheet
    – Future written business
   “Below the line” adjustments to surplus




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Runoff of Existing Balance Sheet

   Earnings are related to:
    – Underwriting profit in UEPR
    – Investment income on assets supporting
      loss reserves and UEPR
    – Investment income on capital supporting
      the runoff



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      Future Written Business

 New and renewal business is not
  usually split for P&C (unlike Life)
 Personal Lines is an exception
 Projections typically made at LOB level




                  35
            Hurdle Rate

 Reflect the cost of acquiring capital
  needed to perform transaction
 Typically provided by management
 Can be estimated by various security
  valuation methods



                  36
    Hurdle Rate Considerations

 Risks attributable to business activities
  of target
 Consideration of multiple hurdle rates
 Method of financing acquisition
 Consistency with other assumptions




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Q&A




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