The value of the firm: the option adjusted value of distributable earnings

  • David N. Becker
  • Kim B. Staking
Chapter
Part of the The New York University Salomon Center Series on Financial Markets and Institutions book series (SALO, volume 1)

Abstract

The goal is to maximize the value of the insurance firm. The first step is to develop the right objective function to measure the firm’s value. The second step is to use the objective function to identify and quantify the risks to which the firm is exposed. The third step is to use the objective function to analyze proposed strategies to maximize the value of the firm relative to risk, i.e. either maximize value given a fixed risk or minimize risk given a fixed value. Such strategies are to be applied to the pricing of new business, the management of in force business and the acquisition/divestiture of blocks of business or entire companies. The challenge is more difficult when the firm is exposed to multiple stochastic risks, many having embedded options and not all of which are independent. The fourth step is to use the objective function to provide management information about the performance of the firm during each time period and to allocate capital to future and existing projects. It would be ideal if the external financial reporting of the firm’s performance could be presented on this basis. In this way the owners of the firm would know its value and income for a given period and be able to assess the impact of management’s actions on that value.

This paper defines such an objective function, demonstrates its properties and shows how the different steps above can be carried out. Since the current accounting environment less accurately quantifies the value and performance of the firm over time, the paper first presents background on the goals and evolution of current accounting systems for life insurance companies, culminating with the environment after the enactment of Financial Accounting Standard 115 and prior to the resolution of the issue of the market value of liabilities.

An overview is provided of several methods of adapting the current accounting structure to accommodate a market value of liabilities. Two of these approaches are examined in some detail. Second, a brief, intuitive presentation on option pricing for assets is given and used to provide the foundation for several potential market values of liabilities. Clarifications between the application of market value concepts to accounting and asset/liability management are given. Limitations of the applicability of these solutions to the issues described above are identified. Third, the proposed objective function is then motivated, defined and explored. Fourth, several concrete examples are provided that demonstrate the capabilities of the tool. Alternative ways of evaluating results are demonstrated and their relationships are shown. Fifth, various general applications of the tool are given that complete and augment the goals stated in the first paragraph.

Although the focus of the paper is on interest rate risk, extensions to other stochastic risks are indicated.

Keywords

Cash Flow Option Price Insurance Enterprise Free Cash Flow Interest Rate Risk 
These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.

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Copyright information

© Springer Science+Business Media Dordrecht 1998

Authors and Affiliations

  • David N. Becker
    • 1
  • Kim B. Staking
    • 2
  1. 1.Lincoln National Life Insurance CompanyUSA
  2. 2.Inter-American Development BankUSA

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