Components of Insurance Firm Value and PV of Liab

Question 1

Formulas for market value of equity

Answer 1

1. Market value of equity = market value of assets - market value of liabilities
   MV(E) = MV(A) - MV(L)
2. Market value of equity = franchise value + market value of tangible assets - present value of liabilities + put option value
   MV(E) = FV + MV(TA) - PV(L) + PO
3. Relationship between market value and firm risk exposure:
   a. MV increases as insolvency risk increases (put option value increases)
   b. MV increases as firm decreases in insolvency risk (franchise value increases)

Question 2

Definition of PV of liabilities (PV(L))

Answer 2

Amount of tangible assets that are required today to satisfy the liabilities.

Question 3

Direct valuation approach of estimating amounts of asset necessary to satisfy liabilities

Answer 3

Focus on net tangible value = MV(TA) - PV(L).

PV(L) = amount of tangible assets required in order to cover expected liabilities.

Net tangible value represents amount required to provide buffer to cover excess of liab over assets.

Question 4

Level of net tangible value reflects (4)

Answer 4

1. ) Deviations from expected claims (actuarial risk)
2. ) Risk that experience deviates from assumptions (model risk)
3. ) Buffer to cover asset default risk, asset liquidity risk, and interest rate risk.
4. ) Amount of riskiness of PV(L) and level of insolvency risk.

Question 5

Advantages of using PV(L) and not MV(L) (6)

Answer 5

1. ) Easier to calculate (doesn’t reflect PO and FV)
2. ) Avoids some difficult valuation issues
3. ) Provided and estimate to regulators on amount required to cover liab
4. ) Estimate can be compared to estimates of other carriers
5. ) Metric useful is assessing risk
6. ) Can be used for financial performance measurement