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.
Comment: This paper could be considered the one most rich in original thought and insight. Like the Academy paper presented by Mr. Hohman and the Dicke paper it includes a review of the underlying accounting principles as well as the introduction on new ideas. The Staking comments are quite useful and incisive. — Ed.
Access this chapter
Tax calculation will be finalised at checkout
Purchases are for personal use only
Preview
Unable to display preview. Download preview PDF.
References
Anderson, J.C.H. (1959). Gross premium calculations and profit measurement for non-participating insurance. TSA, XI, 357–94, Discussion, 395–420.
Atkinson, D.B. (1990). Introduction to Pricing and Asset Shares. Society of Actuaries Study Note 210–25–90.
Babcock, G.C. (1984). Duration as a link between yield and value, Journal of Portfolio Management, Summer, 58–65 and Corrections, Fall 1984: 97–98.
Becker, D.N. (1988). A generalized profits released model for the measurement of return on investment for life mnsurance. TSA, XL, 61–114.
Becker, D.N. (1991). A method for option-adjusted pricing and valuation of insurance products. Product Development News, Society of Actuaries, 30, 1–6.
Becker, D.N. (1984). Pricing for profitability in ART. Best’s Review, (September), 26–28, 154–155. Becker, D. N. and T. Kitsos (1984). Mortality and lapse assumptions in renewable term insurance. Reinsurance Reporter, 104, 9–14.
Bierwag, G.O. (1987). Duration Analysis: Managing Interest Rate Risk. Cambridge, MA: Ballinger Publishing Company.
Bierwag, G.O., G.G. Kaufman, and A. Toevs (1983). Duration: its development and use in bond portfolio management. Financial Analysts Journal, (July—August), 15–35.
Black, F., E. Derman, and W. Toy (1990). A one-factor model of interest rates and its application to treasury bond options. Financial Analysts Journal, 46, 33–39.
Childs, J.F. (1994). Common Stock Cost — The Mystery in Cost-of-Capital. Working paper, Kidder, Peabody & Company, Inc.
Copeland, T.E. and J.F. Weston (1988). Financial Theory and Corporate Policy 3rd edn. Reading, MA: Addison-Wesley Publishing Company.
Cox, J.C., S.A. Ross and M. Rubinstein (1979). Option pricing: a simplified approach. Journal of Financial Economics, 7, 229–263.
Cox, J.C. and M. Rubinstein (1988). Options Markets. Englewood Cliffs, NJ.
Cozzolino, J.M. (1979). New method for risk analysis. Sloan Management Review, (Spring), 53–66.
Dicke, A. (1993). Fair-valuing of insurance liabilities - actuarial approach. Financial Reporter, (June), 14–15.
Dukes, J. and A. MacDonald (1980). Pricing a select and ultimate annual renewable term product. TSA, XXXI, 547–584.
Fabozzi, F.J. (1990). Valuation of Fixed Income Securities. Summit, NJ: Frank J. Fabozzi Associates.
Griffin, M.W. (1990). An excess spread approach to non-participating insurance products. TSA, XLII, 229–246.
Heath, D., R. Jarrow, and A. Morton (1990). Bond pricing and the term structure of interest rates: a discrete time approximation. Journal of Financial and Quantitative Analysis, 25, 419–440.
Ho, T.S.Y. and S.-B. Lee (1986). Term structure movements and pricing interest rate contingent claims. Journal of Finance, 41, 1011–1029.
Ho, T.S.Y. (1990). Strategic Fixed Income Management. Homewood. IL: Dow Jones-Irwin.
Ho, T.S.Y., A.G. Scheitlin. and K.O. Tam (1992). Total Return Approach to Performance Management. Working paper, Metropolitan Life Insurance Company.
Hull, J.C. (1993). Options, Futres, and Other Derivative Securities, 2nd edn. Englewood Cliffs, NJ: Prentice-Hall.
Jacob, D.P., G. Lord, and J.A. Tilley (1987). A generalized framework for pricing contingent cash flows. Financial Management, 16, 5–14.
Jarrow, R.A. (1988). Finance Theory. Englewood Cliffs, NJ: Prentice-Hall, 1988.
Kuhn, T.S. (1970). The Structure of Scientific Revolutions. Chicago, IL: The University of Chicago Press.
Lee. D.S. (1979). A conceptual analysis of nonparticipating life insurance gross premiums and profit formulas, TSA, XXXI, 489–509, Discussion, 511–531.
Lorie, J. and L.J. Savage (1951). Three problems in rationing capital. Journal of Business. 28, 229–239.
McKinsey & Company, Inc. (1990). Cost of Equity Capital Discussion. Working paper. Markowitz, H. (1959). Portfolio Selection. New Haven, CT: Yale University Press.
Miller, L., U. Rajan, U and P. Shimpi (1989). Liability Funding Strategies. In: F. Fabozzi (ed), Fixed Income Portfolio Strategies: State-of-the-Art Technologies and Strategies. Probus Publishing.
Miller, S. (1990). A continuous arbitrage-free interest rate model, part 1. Risks and Rewards, 7, 4–7.
Miller, S. (1991). A continuous arbitrage-free interest rate model, part 2. Risks and Rewards, 10, 5–7.
Miller, S. (1992). A continuous arbitrage-free interest rate model, part 3. Risks and Rewards, 13, 2–6.
Pedersen, H.W., E.S.W. Shiu and A.E. Thorlacius (1989). Arbitrage-free pricing of interest-rate contingent claims. TSA, XLI, 231–265.
Posnak, R. (ed.) (1974). GAAP: Stock Life Companies. Ernst and Young.
Reitano, R.R. (1991a). Multivariate duration analysis. TSA, XLIII, 335–376.
Reitano, R.R. (1991b). Multivariate immunization theory. TSA, XLIII, 393–441.
Shapiro, R. and J. Snyder (1988). Mortality expectations under renewable term insurance. Proceedings, Conference of Actuaries in Public Practice, XXX, 592–614.
Smith, B.M. (1987). Pricing in a return-on-equity environment. TSA, XXXIX, 257–272.
Solomon, E. (1956). The arithmetic of capital budgeting decisions. Journal of Business, 29, 24–29.
Sondergeld, D.R. (1982). Profitability as a return on total capital. TSA, XXXIV, 415–429, Discussion, 431–433.
Tilley, J.A. (1992). An actuarial layman’s guide to building stochastic interest rate generators. TSA, XLIV, 509–564.
Teichroew, D., A. Robichek, and M. Montalbano (1965). An analysis of criteria for investment and financing decisions under certainty. Management Science, (November), 51–79.
Author information
Authors and Affiliations
Editor information
Editors and Affiliations
Rights and permissions
Copyright information
© 1998 Springer Science+Business Media Dordrecht
About this chapter
Cite this chapter
Becker, D.N., Staking, K.B. (1998). The value of the firm: the option adjusted value of distributable earnings. In: Vanderhoof, I.T., Altman, E.I. (eds) The Fair Value of Insurance Liabilities. The New York University Salomon Center Series on Financial Markets and Institutions, vol 1. Springer, Boston, MA. https://doi.org/10.1007/978-1-4757-6732-2_7
Download citation
DOI: https://doi.org/10.1007/978-1-4757-6732-2_7
Publisher Name: Springer, Boston, MA
Print ISBN: 978-1-4419-5178-6
Online ISBN: 978-1-4757-6732-2
eBook Packages: Springer Book Archive