Value and Capital Management: A Handbook for the Finance and Risk Functions of Financial Institutions

Appendix CValuing Banks and Insurers: The Link Between Value and New Business and Investment RAPM

Chapter 5 asserts that RAPMs provide a clear link between risk, capital and the value of the firm. This appendix provides simple examples linking the market valuation formulae developed in the previous appendix to the New Business and Investment RAPMs defined in Chapter 3, using notation specific to the banking and insurance segments.

Valuation of Insurers

In this section, we demonstrate the link between the market-consistent valuation framework and the New Business and Investment RAPMs specific to the PC and LH insurance businesses.

Period Earnings

Without loss of generality, imagine a world with no taxes and all insurance contracts settled within the period that they are contracted: insurance premiums (P) are collected immediately at the start of the period and are invested as reserves to cover claims (C) and expenses (E) which are paid at the end of the period.

The premium is assumed to be invested to perfectly match the claim's best-estimate financial cash flow profile: zero-coupon cash flows are held against PC best-estimate claims and LH policy financial claims are similarly matched using a combination of financial market instruments, potentially including derivatives, so as to replicate the liability's cash flows and embedded options and guarantees in every state of the world.

The company enters the period with their Market Value Surplus (MVS) representing the net shareholder ...