CONTRIBUTORS

EDWARD I. ALTMAN, Ph.D, Edward I. Altman is the Max L. Heine Pro­fessor of Finance at the Stern School of Business, New York University. Since 1990, he has directed the research effort in Fixed Income and Credit Markets at the NYU Salomon Center and is currently the Vice-Director of the Center. Dr. Altman has an international reputation as an expert on cor­porate bankruptcy and credit risk analysis. Professor Altman is one of the founders and an Executive Editor of the international publication, the Journal of Banking and Finance and Advisory Editor of a publisher series, the John Wiley Frontiers in Finance Series. Dr. Altman's primary areas of research include bankruptcy analysis and predication, credit and lending policies, risk management in banking, corporate finance and capital markets. Dr. Altman is Chairman of the Board of Trustees of the Inter­School Orchestras of New York and a member of the Board of Trustees of the Museum of American Financial History.

J. PETER DURAN, Ph.D, FSA, partner, Ernst & Young's National Actuarial Services practice. He leads the firm's New York-based life actuarial consulting practice. He has over 24 years of experience in the life insurance industry, with an emphasis on financial reporting, planning, and

306 CONTRIBUTORS

performance measurement. Prior to joining Ernst & Young, he was with Mass Mutual, where he was vice president and actuary. Mr. Duran is a member of the American Academy of Actuaries' Committee on Life Insur­ance Financial Reporting Principles and of its committee monitoring the development of international accounting standards. He has been a member of the Society of Actuaries' Financial Reporting Section Council and of the Life Practice Advancement Committee and chair of the Professional Actu­arial Specialty Guides Committee and of the Committee on Valuation and Related Matters. Peter coauthored the LOMA monograph "Measuring Financial Performance in the Life Insurance Industry" and is an author of LOMA's forthcoming monograph "Fair-Value Reporting for Life Insurers."

LUKE N. GIRARD, FSA, FCIA, MAAA, CFA, vice president of Lincoln Investment Management Inc. He is responsible for risk management in the investment company and has been responsible for providing asset and liability management services to clients. Prior to joining LIM he was vice president of Lincoln Life, responsible for marketing and managing pension investment products. He joined the company after serving as a product­development actuary for Great West Life. He has served on various indus­try committees, including the Education and Examination Committee that designed the finance specialty track of the Fellowship examinations and the Investment Section Council. He is also a past editor of the Risks and Rewards newsletter. He has written articles and is an occasional speaker on the subject of fair valuation of liabilities. Mr. Girard is a fellow of the Society of Actuaries, a member of the American Academy of Actuaries, and a fellow of the Canadian Institute of Actuaries. He is a member of the Association of Investment Management and Research.

SAM GUTfERMAN, FSA, FCAS, FCA, MAAA, director and consulting actuary, Price waterhouse Coopers LLP, Chicago. He is currently is a member of the International Accounting Standards Committee's (lASe) Steering Committee on Discounting and chair of the International Actuarial Association's (IAA) Committee on IASC Insurance Accounting Standards. Mr. Gutterman has been active in a number of actuarial activities, including service as president of the Society of Actuaries from 1995 to 1996.

R. THOMAS HERGET, FSA, MAAA, Executive vice President, PolySystems, Inc. After graduating from the University of Illinois he worked with the Hartford, Peat Marwick, and CNA before joining his current firm. He has performed as chair of the Society of Actuaries' Financial Report-

CONTRIBUTORS 307

ing Section and has served on the State Variations and Unified Valuation System Task Forces of the American Academy of Actuaries. Mr. Herget has served as appointed actuary and currently oversees the implementa· tion and consulting practices for PolySystems' valuation and performance measurement software.

THOMAS S.Y. HO, Ph.D, was, at the time of the conference executive vict! President, BARRA, Inc. He headed the Research Group in New York City. He joined BARRA when the firm merged with Global Advanced Tech·· nology (GAT) in June 1997. When Mr. Ho founded GAT in 1987, he deveI-· oped cutting-edge technology for delivering innovative solutions to 250 major institutional clients. Within 10 years GAT annual revenues reached $10 million. He continues his extensive consulting research in risk man·· agement, financial modeling, financial institutions' liability modeling, and investment processes. The Research Group provides consultation services including portfolio valuations, risk management, and value at risk. Tom has published extensively in major journals, including Journal of Finance, Journal of Derivatives, Journal of Fixed Income, and Journal of Portfolio Management. He was professor of finance at New York University's Stern School of Business from 1978 until 1990.

MARY LYNN MICHEL, Ph.D, assistant professor of Accounting, Man­hattan College, New York. As a member of the graduate faculty, she teaches financial-statement analysis. She is also on the faculty team of the Finance and Accounting for the Non-Financial Executive program for Columbia University Executive Programs. She received her Ph.D. in accounting from Columbia University and holds a master of science in industrial adminis­tration from Carnegie Mellon University. She has lectured on fair-value accounting and the life insurance industry at several conferences sponsored by the American Accounting Association. She has also submitted her research results on this topic to the Financial Accounting Standards Board. Prior to her academic career, Ms. Michel was an assistant vice president/senior business analyst for the investment-management firm Scudder, Stevens & Clark. She was an assistant manager in the Manage­ment Reporting and Analysis department of Chemical Bank, where she developed and implemented management-accounting policies.

IRWIN VANDERHOOF, Ph.D, FSA, ACAS, MAAA, AlA, CFA, ChLU, FLMI, clinical professor of Finance, Stern School of Business, New York University, His current research interests include yield-curve empirical studies, performance measurement and fixed income, asset loss, risk

308 CONTRIBUTORS

management in life insurance investing, Lyme disease symptoms and costs, and improvements in Monte Carlo method calculations. Mr. Vander­hoof is the founder of Actuarial Investment Consulting, whose clients include Equitable Life, Goldman Sachs, Lutheran Brotherhood, Ernst and Young, Life Insurance Company of the South West, Tillinghast, John Hancock Life, Nippon Life Insurance Company of American, Milliman and Robertson, Bankers Trust, the New Jersey Insurance Department, and the State of Florida Insurance Department. In addition, he served at Equitable Life as the chief actuary and the chief investment officer for Individual Lines, Small Pension, GICs and the Asset Policy Office. He has published extensively. His most recent publications include Strategic Dynamics of the Insurance Industry with Edward Altman (Irwin, 1996) and Fair Value of Life Insurance Liabilities with Edward Altman (Kluwer Academic Press, 1998). He is a coinventor with Joseph Traub and Spassimir Paskov in the use of low discrepancy points for the calculation of values of complex financial instruments.

ANDRES VILMS, M.S., consulting actuary, Ernst & Young LLP. He advises clients on matters relating primarily to asset and liability manage­ment and financial reporting. His projects include stochastic modeling, option pricing of insurance products, and evaluation of hedging strategies. He is an associate of the Society of Actuaries.

MARSHA WALLACE, CFA, MBA, second vice president in charge of asset/liability management in the Corporate Actuarial area at Transamer­ica Occidental Life Insurance Company. She has extensive experience with asset and liability management at the corporate and line levels. In her current capacity, she has done significant pilot testing of a framework for fair valuation of liabilities within Transamerica. She has spoken on "Transfer Pricing" at the 1997 Global Advanced Technology conference and has authored a paper on the same subject. Prior to joining Transamer­ica, Ms. Wallace spent three years working in a financial capacity for First Interstate Bank of California, including two years in asset and liability management.

Index

AAM, see Actuarial-appraisal method ABCD methodology, see Arbitrage­

free bond canonical decomposition

Accidental-death benefits (ABD) table, 268

Accounting Standards Board (ASB), 70-71

Accounting systems conceptual-valuation approach vs.

current, 165-168 defined, 126 future cash flow valuation and, 67-69 generally accepted, see Generally

accepted accounting principles for life insurance companies, 195-199 statutory, see Statutory accounting tax-neutral, 27, 35 term insurance and, 284-285

Actuarial-appraisal method (AAM), viii, 4,30,35-36, 135-136,223, see also Indirect method

with leverage adjusted cost of capital, 19-20

option-pricing equivalence to, 12-14 overview of, 6-7

Actuarial Standard of Practice No. 19: Actuarial Appraisals, 7

Adverse-selection risk, 78 AI CPA Statement of Position (SOP)

90-11,198 Allied Life, 203

Altman, E. 1.,223 American Academy of Actuaries, 3,

108,135,285 American Annuity, 203 American Income Holding, 203 American Stock Exchange, 203 Annuities

single-premium deferred, see Single­premium deferred annuities

variable, 98 AON,21O Applicability, 150 A-rated curve, 139, 144, 151 Arbitrage-free assumption, 138 Arbitrage-free bond canonical

decomposition (ABCD), 170, 178, 180f,188-189

Arbitrage-free interest rates, 139, 143, 225,232,242

ASB, see Accounting Standards Board Asian financial crisis, 83, 84 Asset and liability matching, 211-213 Asset and liability mismatch risk, 78,

95,99 Asset cash flows, 162 Asset earnings rates, 227, 233, 240-242 Asset portfolios, 173, 178-181,230 Asset profiles, 157, 158f, 163, 164f, 165f Assets

book value of, 154-157, 167 conceptual-valuation approach and,

165-168

310

defined, 126 in fair-value accounting, 154-157 future cash flow valuation and, 63,

64,67-68 investment, 222 liability valuation independent of,

150 market value of, see Market value of

assets as mutually exclusive from liabilities,

137 noninterest-sensitive liability

benchmarks and, 181-185 obligations and, 105-107 short-duration contracts and, 195 statutory value of, 27n, 29 surplus valuation and, 162-165 tax value of, 4, 8,12,29,34 universal-life-type contracts and, 198

Audiences, 65-67, 125,165

Babbel, D. F., 13n Baird, P. S., 7, 15 Balanced investment strategies, 231 ,

234,236,239,260 Balance sheets, 67, 194, 203 Banker's Life, 203 Banks, 191,213-215 BARRA, 154, 170, 172, 183, 188 Barth, M., 191, 193, 195,202, 208 Baseline economic scenario

defined, 232-233 lapse rates and, 263f single-path valuation and, 232-242 stochastic valuation and, 242-249

Beaver, W., 193 Becker, D., 7, 269 Beeson, M., 150 Benchmarks

assets relative to noninterest­sensitive liability, 181-185

for future cash flow valuation, 70, 72, 73

for interest-sensitive liabilities, 178-181

for noninterest-sensitive liabilities, 172-178

for risk, 81 Benefit cash flows, 5

INDEX

Binomial lattices, 143, 144, 145-146, 147f,148

Black, F., 97 Bonds, 80, 157, 222, 260

noncallable, 71 Treasur~ 194, 198,213 zero-coupon corporate A, 173, 179,

183 Book value

of assets, 154-157, 167 historical-cost, see Historical-cost

book values of liabilities, 157-162, 167-168 of surplus, 162, 164-165

Boundary-value assumption, 138 Bragg, J. , 268-269 Business risk, 79, 95

Capital-asset-pricing method (CAPM), 91, 163

Capital growth, 57-58 Capital risk, see Insolvency risk CAPM, see Capital-asset-pricing

method Cash-flow models, 126 Cash flows

asset, 162 benefit, 5 debt -service, 17 discount rates and, 107-108 entity-specific, see Entity-specific

value expense, 5, 9 fair-value financial reporting models

and, 222 free, 6, 7, 27, 135 interest-sensitive, 225-226 liability, see Liability cash flows negative, see Negative cash flows positive, 57, 58, 59-60, 63,108-109 premium, 5 price-based discounted, see Price­

based discounted cash-flow method

required profit, 9 single-path, see Single-path

valuation stochastic, see Stochastic valuation surplus valuation and, 162-164

INDEX

valuation of future, see Future cash flow valuation

Catastrophe risk, 62 CCp, 203 Chen, M. Z. H., 170 Citizens Financial Kentucky, 203 Citizens Inc., 210 Clairvoyance of reserves, 284 Combination risk, 78 Commissioner's Reserve Valuation

Method (CRVM), 239, 270-271, 301-302

Compact Disclosure Database, 203, 204-205t

Comparability, 119 Completeness, 120 Compound rate of interest, 109 Compression, 300 Conseco, 210 Conservatism, 94 Consistency, 150, 302 Contagion risk, 79 Convergence, 26 Convexity, 155, 159, 183, 184 Copeland, T. E., 14 Cost of capital, 32

leverage adjusted, see Leverage adjusted cost of capital

net of inflation, 58 weighted average, 20-21n

Counterparty risk, see Credit risk Country (sovereign) risk, 79 Cox, 1. C, 30 Creditors, 67 Credit risk, 77-78, 80,111-113,151 Credit spread, 136, 141, 142, 148-149

defined, 139 determination of, 140

CRVM, see Commissioner's Reserve Valuation Method

Current-asset earned (coupon) rate, 102 Current borrowing rate, 102 Current market rate, 102 Current settlement rate, 102 Current values, 68-69

DOE, see Discounted distributable earnings

DE, see Distributable earnings

311

Death claims, 271, 286, 289 Debt market value, see Market value

of debt Debt-service cash flows, 17 Default risk, 88,111-113 Deferred policy-acquisition cost

(DPAC), 197, 198, 199 Direct method, viii, 223-224, see also

Option-pricing method Direct observation, 91 Dirty surplus, 201 Disclosure, 74,122-123, see also Fair­

value disclosures Discounted distributable earnings

(DOE), 4, 6, 12,35 decomposition of, 7-8, 26, 33t, 34t leverage adjusted cost of capital and,

21-22,33t market value of assets and, 9 market value of liabilities and, 7-8,

9-10 Modigliani and Miller propositions

and, 16-18 risk-neutral valuation and, 34t

Discount rates bases for selection of, 102-103 cash flows and, 107-108 default risk and, 111-113 defined, 123-124 dynamically adjusted, 113-114 entity-specific value and, 104-115 future cash flow valuation and,

100-117,118-119,123-125 interest earnings and, 124 large-scale capital investment

projects and, 117 liability, 28-28 life insurance and, 118 locked-in, 113-114 market value of liabilities and, 140,

151 multiple equivalent, 124-125 nominal or real basis for, 111 obligation and asset relationship in,

105-107 option-pricing method and, 5 present-value models and, 100-102 property and casualty loss provisions

and, 118-119

312

retirement programs and, 116-117 risk, see Risk discount rates risk-adjusted, 87 risk-free, see Risk-free rates single-premium deferred annuities

and, 226, 227-228, 233 structure of, 109-111 surplus valuation and, 162-163 taxes and, 114-116 term insurance and, 294-296, 301 time, 129 time value of money and, 103-105 total, 60-61, 130

Distributable earnings (DE) , 6, see also Discounted distributable earnings

Diversifiable risk, 81 , 83 defined, 126

Diversification, 126 Dixit, A. K. , 30 DnDn Path, 30, 3lt DnUp Path, 30, 3lt Doll, D. c., vii, 3, 12, 135 Dothan, U. D., 30 DPAC, see Deferred policy-acquisition

cost Dukes, J. , 269 Duration, 173, 183, 184

of equity and surplus, 262 key rate, 173, 183, 184 of liabilities, 159

Dynamically adjusted discount rates, 113-114

Dynamic models/systems, 62, 90, 97-98

Earnings asset rates, 227, 233, 240-242 discounted distributable, see

Discounted distributable earnings

distributable, 6 distributed to shareholders, 284-285 fair-value, see Fair-value earnings interest, see Interest earnings stock valuation and, 191 , 192,

199-201, 210, 211,215 term insurance, 178, 284-285, 300

Easton, P, 201 Eccher, A., 193 Economic good, 127

Eddey, P, 201 Efficient frontier, 184, 185f Efficient markets

defined, 127

INDEX

future cash flow valuation and, 52- 55, 73, 76

risk and, 94-95 Embedded value (EV), 10, 11 Emotion, 83-84 Enterprise risk, 93 Entity-specific value, 70-71, 86, 90-91,

104-105 defined, 127

Epsilon decomposition, 265-266 EV, see Embedded value Event risk, 95- 96 Expected earned or credited rate,

102-103 Expected value, 55-56, 123, 289

defined, 127 Expense and inflation risk, 79-80 Expense cash flows, 5, 9 Expenses, 195, 197, 198 Ezzell, 1. R. , 20n

Fact and circumstance rate, 102 Fair valuation of liabilities, 158-162,

163, 164 deductive methodology, 11- 12 for single-premium deferred

annuities, 223-231 Fair Valuation of Liabilities Task Force,

3-4 Fair value

comparison of approaches, 241-242 criteria for, 150-152 defined,53,127,221

Fair-vlaue accounting, 153-189, see also Conceptual-valuation approach; New performance measurement framework

asset valuation and, 154-157 conceptual foundations underlying,

154-165 liability valuation and, 157-162 surplus valuation and, 162-165

Fair-value disclosures, 191 , 192, 193-194,197,213-215

asset and liability matching and, 211

INDEX

investments and, 198-199 regression results, 208-209 value relevance of, 199,200,201-

202 Fair-value earnings, 240-241, 242-248,

259 interest-rate bets and, 260-261 interest-rate drop and, 255-258 interest-rate spikes and, 249-254 liability cash flows and, 262-264 mathematical formulation for,

236-238 under price-based discounted cash­

flow method, 233-236 Fair-value financial reporting models,

221-266 framework for, 231-232 interest-rate bets and, 260-261 interest-rate drop and, 255-258, 261 interest-rate spikes and, 249-254,

260-261 liability cash flows and, 262-264 risk and, 226-227 risk-based capital and, 261-262 single-path valuation and, 225-226,

232-242,243,244-248 stochastic valuation and, 225-226,

242-249 Fair Value of Insurance Business

(conference), vii Fair Value of Insurance Liabilities

(conference), vii, 3 FASB, see Financial Accounting

Standards Board Federation des Experts Comptables

Europeen, 215 Feedback loop, 301 F-factors, 21, 24-26 Financial Accounting Standards Board

(FASB), vii, viii, 70,195,221 Financial analysts, 67 Financial risk, 95 Finite-life adjustment (FLA), 20n, 21

N-period case, 24, 38, 46 one-period case, 37-41 risk-neutral F-factors and, 25-26 two-period case, 42-45

FLA, see Finite-life adjustment Floating-rate liability, 258

313

Follow-the-market (FfM) strategy, 222, 230,232,240,249

fair-value earnings and, 233-234, 235f,243-246

interest-rate drop and, 255-258 interest-rate spikes and, 250-254

Force of interest (discount), 124 Foreign-currency risk, 78, 79 Forward volatilities, 144-145 Free cash flows, 6, 7, 27, 135 Froelich, R., 54 FfM, see Follow-the-market strategy Future cash flow valuation, 49-130

applications of, 116-119 approaches to, 50-55 audiences and, 65-67,125 criteria to judge usefulness of,

119-122 disclosure and, 74, 122-123 discount rates and, 100-117, 118-119,

123-125 present-value models of, 51-63, 70,

73-75,76,77,86,100-102,125 risk and,61-63,64,68, 75-100,116 set of cash-flows in, 63-65 technical issues, 123-125 valuation models and accounting

rules in, 67-69

GAAP, see Generally accepted accounting principles

Gain-one-sale value, 151 Gain or loss at contract issue, 224-225,

242,243 Generally accepted accounting

principles (GAAP), 12, 150, 166

Income Statement, 175, 176-177t single-premium deferred annuities

and, 238f, 239, 254, 255f, 259, 261,262,264

stock valuation and, 195, 196t, 200 term insurance and, 285, 286, 287f,

293,300,302 G-factors, 21, 24, 25 GIC, see Guaranteed investment

contracts Girard, L. N., 7, 8, 136, 141, 167 Girsanov's theorem, 30

314

Global Advanced Technology, 154, 170, 172,183,188

Goodwill, 64, 112 GPV, see Gross premium valuation Griffin, M., 223 Gross-gross method, 114-115 Gross premium valuation (GPV), 272,

282, 283f, 284, 292f, 293f, 294f, 295f, 296f, 297f, 298

Guaranteed investment contracts (GIC), 16, 29-34, 137

Guinn, P. L., 7, 15

Harris, T., 201 Heath, D., 30 Hedges

defined, 127 future cash flow valuation and, 81,

88,96-97,98,99,118 new performance measurement

framework and, 179, 180 Hekman, P. A., vii Historical-cost book values, 191, 192,

193-194,215 correlation with other variables, 206,

208 regression results, 208-209 regression results excluding outliers,

210 univariate analysis of, 205 value relevance of, 199-203

Historical values, 68-69 Ho, T. S. y., 30, 136, 141, 170 Hull, 1. C, 30 Hurdle rate, 103, 117 Hwei-Chung Shao, S., vii

lAS 19,104 lAS 37, 121 IASC, see International Accounting

Standards Committee Imperfect markets, 15,72-73 Implied forward curve, 225, 231, 232,

233,234,264 Income statements, 67,194,203

GAAP, 175, 176-177t term insurance, 285

Income taxes, 199,229 Indirect method, 223-224, see also

Actuarial-appraisal method Industry risk, 79 Inefficient markets, 52-53, 72 Inflation, 57

INDEX

In-force-business assumption, 138 Information risk, 78 Ingersoll, 1. E. , 30 Insolvency risk, 79, 91 Insurer credit standing, 230-231 Interest earnings

discounting, 124 universal-life-type contracts and,

198 Interest maintenance reserve (IMR),

259 Interest-rate risk, 80, 98 Interest rates

arbitrage-free, 139, 143,225,232,242 bets, 260-261 compound, 109 conceptual-valuation approach and,

166-167 defined, 124 drop in, 255-258, 261 fair-value accounting and, 153, 155-

157, 158-159, 160-162, 164-165 fair-value financial reporting models

and, 146-149,231,245,246, 247-248, 249-258,260-261

implied forward curve and, 225, 231, 232,233,234, 264

market value of liabilities and, 29-34 option-pricing method and, 5 real, 57, 103 risk-free, see Risk-free rates spikes in, 249-254, 260-261 stock valuation and, 192 structure of, 232

Interest-rate sensitivity, 213 Interest-sensitive cash flows, 225-226 Interest-sensitive liabilities, 170,

178-181 International Accounting Standards

Committee (lASC), 195,215 Investment assets, 222 Investment income, 285 Investments, 198-199,200

large-scale capital in, 117 realized gains and losses, 259

INDEX

Investment strategies actuarial-appraisal method and, 7 balanced,231,234,236,239,260 long,234,236,246-247,260 market value of liabilities and,

26-28 option-pricing method and, 5, 6 short, 245

Jaffe, 1., 268 Jarrow, R., 30 John Alden, 203

Key rate durations (KRDs), 173, 183, 184

Kitsos, T., 269

Landsman, w., 193 Lapse function, 142, 148 Lapse rates

for single-premium deferred annuities, 142,229,262-264

for term insurance, 269-270, 271, 291, 292t293-294,300

Large-scale capital investment projects, 117

Lee, S. B., 30 Leibowitz, M., 203 Lemming (bubble) aspect of risk,

83-84 Leverage adjusted cost of capital,

33-34,35,37-46 actuarial-appraisal method with,

19-20 characteristics of, 21-22 N-period case, 20-21, 45-46 one-period case, 37-41 risk and, 22, 23f

Liabilities book value of, 157-162, 167-168 conceptual-valuation approach and,

165-168 defined,l27 duration of, 159 fair valuation of, see Fair valuation of

liabilities fair-value accounting for, see Fair­

value accounting floating-rate, 258

315

future cash flow valuation and, 63, 64,67-{)8

interest-sensitive, 170, 178-181 long-duration contracts and, 197 market value of, see Market value of

liabilities as mutually exclusive from assets,

137 new performance measurement

framework and, 186-187 noninterest-sensitive, see

Noninterest-sensitive liabilities short-duration contracts and, 195 statutory value of, 27, 29 surplus valuation and, 162-165 tax value of, 4, 8, 29, 34 universal-life-type contracts and, 198 valuation of, 157-162

Liability cash flows, 9 fair-value financial reporting models

and,262-264 in option-pricing method, 5 surplus valuation and, 162 updating assumptions for, 229-230

Liability discount rates, 28-28 Liability models, 137-141 Liability profiles, 16lf, 162, 163, 164f,

165f Liability risk, 78 Liability spread, 227-228, 233, 236, 237,

240f,242 Liability total return, 236-238, 248-249 Liability valuation spread (LVS), 249,

264 Life insurance companies, 191-216

accounting in, 195-199 asset profiles of, 157, 158f, 163, 164f,

165f future cash flow valuation and, 118 investments and, 198-199,200 liability profiles of, 16lf, 162, 163,

164f,165f long-duration contracts in, 197 short-duration contracts in, 195-197 universal-life-type contracts in,

198 Life Partners Group, 203 Life RE, 203 Life USA, 203

316

Lintner, 1., 163 Liquidity premium, 15, 34 Liquidity risk, 78-79 Locked-in discount rates, 113-114 Lognormal model, 143 Long-duration contracts, 197 Long investment strategies, 234, 236,

246-247, 260 Long-Term Capital Management, 79,

83, 301 Loss recognition, 293

MacDonald, A. M., 269 Management, 66, 85, 86 Manhattan Life, 203 Market discount, 54 Market preceptions, 83-84 Market price, 50, 54

defined, 52, 128 Market risk, 78 Markets

defined, 127 efficient, see Efficient markets imperfect, 15,72-73 inefficient, 52-53, 72 perfect, see Perfect markets thinly traded, 72, 73

Market-to-book ratios, 193, 203 Market value, 54

defined, 52-53, 128 in stock valuation, 193-194,200

Market-value models, 86 Market value of assets (MVA), 4, 7-8,

12,35 conceptual-valuation approach and,

165, 167-168 description of, 9 fair-value accounting and, 154-

157 leverage adjusted cost of capital and,

20 Modigliani and Miller propositions

and, 16-19 new performance measurement

framework and, 171 Market value of debt (MVD), 26-28

liability discount rates and, 28-29 Modigliani and Miller propositions

and, 16-19 risk-neutral F-factors and, 25

INDEX

Market value of liabilities (MVL), 3-46,135-152

actuarial-appraisal method in, see Actuarial-appraisal method

conceptual-valuation approach and, 165, 167

credit spread and, 136, 139, 140, 141, 142, 148-149

criteria for, 150-152 description of, 9-10 discounted distributable earnings

and, 7-8, 9-10 fair-value accounting and, 157-162 formula for, 12-13 GIC example of, 29-34 introduction of concept, 4 investment strategy and, 26-28 liability model for, 137-141 market value of debt distinguished

from, 17 new performance measurement

framework and, 171 option-pricing method in, see

Option-pricing method in perfect markets, 4,10, 14-29 profit release and, 136, 139, 140, 141 ,

142, 148-149, 151 , 152 risk-based capital and, 26-28 statutory accounting and, 26-28 transfer pricing and, 136, 139, 141,

151 Market value of surplus, 162-164 Market value of taxes (MVT) , 24-26 Markowitz, H., 97 Mathematical formulations

for single-path valuation, 236-238 for stochastic valuation, 248-249

McLaughlin, S. M., vii, 150 McQueen, P., vii Merfeld, T. 1., 13 Merton, R. c., 14 Miles, 1. A., 20n Millar, S. K., 7 Miller, F. H., see Modigliani and Miller

propositions Miller, M., 97 M&M propositions, see Modigliani and

Miller propositions Model risk, 62, 82

defined, 128

INDEX

Modigliani and Miller (M&M) ropositions, 14-15,32,37-46

comparision with author's work, 36-37

one-period case, 37-41 Proposition 1,18,39,43 Proposition II, 18,40,43 steady-state case, 16-19,20,24,37 two-period case, 42-45

Mohey-Deen, Z., vii Monte Carlo approach, 267,271-283,

284,286,289, 290f, 291, 298-300, 301 Moral hazard, 78 Mortality rates, 229, 267-269, 270, 271,

287, 291,292L 293-294, 295L 298, 299f,300

Morton, A., 30 Multiple equivalent discount rates,

124-125 MVA, see Market value of assets MVD, see Market value of debt MVL, see Market value of liabilities

NASDAQ, 203 Negative cash flows, 17, 57, 58, 59, 63,

98-99, 108-109 Nelson, K., 193, 195 Net-net method, 114 New performance measurement

framework, 168-187 goals of, 168-170 pilot testing of, 172-185 uses of, 170-172

New York Stock Exchange, 54, 203 Nominal discount basis, 111 Noncallable bonds, 71 Nondiversifiable risk, 81, 82-83

defined, 128 Noninterest-sensitive liabilities

benchmarks for, 172-178 optimizing assets relative to

benchmarks, 181-185 Normal model, 143 N-period case, 20-21, 24, 38, 45-46

OAS, see Option-adjusted spread Objectivity, 121, 150 Obligations, 63, see also Liabilities

assets and, 105-107 defined,128

Ohlson theoretical model, 194, 195, 199-200,215

One-period case, 37-41 One-sided risk, 94 Operational risk, 79, 95

317

OPM, see Option-pricing method Option-adjusted spread (OAS), 92,139,

140,141,144,183, see also Required option-adjusted spread

Option-pricing method (OPM), 4, 30, 35-36, 135-136, see also Direct method

actuarial-appraisal equivalence to, 12-14

future cash flow valuation and,51, 62-63

large-scale capital investment projects and, 117

overview of, 5-6 for single-premium deferred

annuities, 142 Option theory, 92 Ostaszewski, K. M., 15 Owners, 65

PAD, see Provision for adverse deviations

Parameter risk, 62, 82 defined, 128

PA strategy, see Portfolio-average strategy

Pathwise values, 148 PBDCFM, see Price-based discounted

cash-flow method PIBHVC, see Price-to-historical-cost

book value Pearson correlations, 206, 207t Pedersen, H. w., 30 Pension Benefit Guarantee

Corporation, U. S., 97 Perfect markets, 4,10,14-29,35, see

also Leverage adjusted cost of capital; Modigliani and Miller propositions

Peterson, R., 213 Petroni, K., 191, 193, 195, 202, 208 Pindyck, R. S., 30 Portfolio-average (PA) strategy, 222,

231,240,249

318

fair-value earnings and, 233-236, 243-246, 248f, 253f, 257f, 263f

GAAP earnings and, 259 interest-rate drop and, 255-258 interest-rate spikes and, 250-254

Positive cash flows, 57, 58, 59-60, 63, 108-109

Premium cash flows, 5 Premiums, 195, 197, 198 Present value (PV)

defined, 53, 128 recognition of, 73-75 surplus valuation and, 162, 164

Present-value (PV) models, 51-63, 70, 76,77,86,125

defined, 128 discount rates and, 100-102 major components of, 55-63

Price-based discounted cash-flow method (PBDCFM), 228, 229, 233-236,242,243

Price-to-historical-cost book value (1 PIBHVC), 206, 208, 209t, 210, 215

Pricing risk, 78 Probability, defined, 128 Process risk, 61

defined, 128 Profit and loss (P&L) statements, 171,

173,175-178 Profit release, 136, 141, 151, 152

defined, 139 determination of, 140 single-premium deferred annuities

and, 142,148-149 Project Oversight Group, Society of

Actuaries, vii-viii Property and casualty insurers

future cash flow valuation and, 118-119

stock valuation and, 191, 192, 194-197,213-214

Prospective-cash-flow assumption, 138 Prospective values, 68-69 Protective Life, 211 Provision for adverse deviations

(PAD), 90-91, 98, 107, 109 defined, 129

Prudence, 94

Prudent margins, 91-92 PV, see Present value

Ramesh, K., 193 Random fluctuations, 94 Rating agencies, 67 RBC, see Risk-based capital Real discount basis, 111 Real interest rate, 57,103 Realism, 121 Realized gains

investment, 259 security, 201, 205, 208, 210, 211

Realized losses, 259 Regulators, 66-67 Regulatory or required rate, 103 Regulatory reporting, 68 Reinsurance, 97 Reinvestment risk, 78

INDEX

Reitano, R. R., 5, 26, 135, 136, 141,223 Relevance, 119-120 Reliability, 120 Reputation risk, 79 Required option-adjusted spread

(ROAS), 139, 140, 144, 148, 149 Required profit (RP), 14

description of, 10-11 leveraged adjusted cost of capital

and, 19-20 Required profit (RP) cash flows, 9 Required surplus (RS), 4, 8, 16-18, 32,

34 Reserve release, 151 Reserves

clairvoyance of, 284 environment for preparing, 302 S-curve,284, 285,286-287, 296-298

Residucal value, 57-58 Retirement programs, 116-117 Return on equity (ROE), 194,208,233,

238 Revenues, 195, 197, 198 Riggieri, A. A., 7 Risk

adverse-selection, 78 asset and liability mismatch, 78, 95,

99 business, 79, 95 capital, see Risk, insolvency

INDEX

catastrophe, 62 combination, 78 concept of, 75-84 contagion, 79 country (sovereign), 79 credit, 77-78, 80, 111-113 default, 88, 111-113 defined, 129 diversifiable, 81, 83, 126 enterprise, 93 event, 95-96 expense and inflation, 79-80 fair-value financial reporting models

and, 226-227 financial, 95 foreign-currency, 78, 79 future cash flow valuation and,

61-63,64,68,75-100,116 industry, 79 information, 78 insolvency, 79, 91 interest-rate, 80, 98 lemming (bubble) aspect of, 83-84 leverage adjusted cost of capital and,

22,23f liability, 78 life insurance and, 118 liquidity, 78-79 market, 78 model, 62, 82,128 nondiversifiable, 81, 82-83,128 one-sided, 94 operational, 79, 95 parameter, 62,82, 128 in present-value model, 61-63, 76, 77,

86 pricing, 78 process, 61,128 property and casualty loss provisions

and, 118-119 reinvestment, 78 reputation, 79 retirement programs and, 116 specification, 62 tax or legal, 80 term insurance and, 267-270 two-sided, 94 viewpoint and, 84-86

Risk-adjusted discount rates, 87

Risk adjustment application of, 86-90 methodolgies for, 90-95

Risk analysis, 75-76 Risk assessment, 86 Risk aversion, 59-60

319

Risk-based capital (RBC), 11, 34, 35, 68 actuarial-appraisal method and, 7 fair-value financial reporting models

and, 261-262 market value of liabilities and, 26-28 option-pricing method and, 5, 6 term insurance and, 284, 285

Risk discount rates, 60, 87-90, 96, 98-100,226

defined,129 Risk-free rates, 87, 89, 90,111

defined, 129 market value of liabilities and, 13 for non interest-sensitive liabilities,

183 option-pricing method and, 5 surplus valuation and, 163

Risk management, 76, 95-100,120 defined, 129

Risk margins, 88 Risk-neutral F-factors, 24-26 Risk-neutral valuation, 30-31, 33-34, 35 Risk preference, 59-60 Risk premiums, 60, 81, 82, 83-84, 87, 91

fair-value accounting and, 163 market value of liabilities and, 13 risk management and, 95 viewpoint and, 85-86

ROAS, see Required option-adjusted spread

ROE, see Return on equity Ross, S. A., 30 RP, see Required profit RS, see Required surplus Ruin theory, 92

Salomon Center, Stern School of Business, vii, 3

Scenario tests, 93 Scheitlin, A., 136, 141 Scholes, M., 97 Scott, w., 213 Scudder Kemper Investments, 54

320

S-curves, 284-289,291, 296-298 Securities and Exchange Commission

(SEC), 168 Security gains, 215

realized, 201,205,208,210, 211 unrealized, 201, 202, 203, 205,

206-208,211 Sensitivity analysis, 209-213 SFAS 60, 196t, 197, 198, 199,215 SFAS 97, 196t, 198,215 SFAS 107,193, 196t, 197, 198, 199 SFAS 113, 196t SFAS 115,3,167, 196t, 198, 199 SFAS 120, 196t Shareholders, 65, 284-285 Sharpe, W. F., 163 Shiu, E. S. w., 30 Short-duration contracts, 195-197 Short investment strategies, 245 Short rate, 232, 234, 236, 237, 240 Simplicity, 121, 150 Single-path valuation, 225-226, 232-

242 interest-rate spikes and, 249-251 mathematical formulation for,

236-238 stochastic valuation compared with,

243,244-248 Single-premium deferred annuities

(SPDA) fair-value accounting and, 159-162 fair-value financial reporting models

for, 221-266 product description and assumptions,

265 valuing, 136, 137, 142-149, 150

Society of Actuaries, vii, 3, 268 SPDA, see Single-premium deferred

annuities Spearman rank correlations, 206, 207t Specification risk, 62 Spot rates,S, 102 Treasur~233,236,240

Spot volatilities, 145 Spread,S

credit, see Credit spread liability, 227-228, 233, 236, 237, 240f,

242 liability valuation, 249, 264

INDEX

option-adjusted, 92, 139, 140, 141, 144, 183

required option-adjusted, 139, 140, 144, 148, 149

SS&C PTS + TM + System, 243 Standard & Poor's Daily Stock Price

Record, 203, 213 State, 5,29 Statutory accounting, 35

actuarial-appraisal method and, 6, 7 conceptual-valuation approach vs.,

166 market value of liabilities and, 26-28 option-pricing method and,S, 6 single-premium deferred annuities

and,239,261,262 term insurance and, 284, 285, 286,

287L 293, 300, 302 Statutory value of assets (SVA), 27n,

29 Statutory value of liabilities (SVL), 27,

29 Steady-state case, 16-19, 20-21, 24, 37 Stern School of Business, New York

University, vii, 3 Stochastic valuation

fair-value financial reporting models and, 225-226, 242-249

interest-rate spikes and, 249-251 mathematical formulation for,

248-249 risk in, 61-62, 88, 90, 92 single-path valuation compared with,

243,244-248 Stock valuation, 191-216

annual regressions in, 211 asset and liability matching in,

211-213 correlation among variables, 206-208 earnings and, 191, 192, 199-201,210,

211,215 empirical analysis in, 203-209 fair-value disclosures and, see Fair­

value disclosures historical-cost book values and, see

Historical-cost book values interest-rate sensitivity and, 213 prior research in, 193-195 regression results, 208-209

INDEX

regression results excluding outliers, 209-211

research design for, 199-203 sample selection for, 203 sensitivity analysis in, 209-213 univariate analysis in, 203-205, 206t

Structure of interest rates, 232 Summers, L., 54 Surplus

conceptual-valuation approach and, 167-168

dirty, 201 in fair-value accounting, 162-165 required, 4, 8,16-18,32,34 stock valuation and, 200

Surplus-at-risk, see Value-at-risk Surrender charges, 222, 227, 253, 262,

263 SVA, see Statutory value of assets SVL, see Statutory value of liabilities Symmetry, 121

Tam, K., 136, 141 Tax authorities, 66 Taxes

actuarial-appraisal method and, 7 discount rates and, 114-116 income, 199,229 market value of, 24-26 market value of liabilities and, 26-27 option-pricing method and, 5, 6 stock valuation and, 201

Tax financial reporting, 68 Tax-neutral accounting, 27, 35 Tax or legal risk, 80 Tax value of assets (TVA), 4, 8, 12,29,

34 Tax value of liabilities (TVL), 4, 8, 29,

34 Term insurance, 267-302

analysis of variations, 289-294 implementation issues, 298-300 Monte Carlo approach and, 267,

271-283, 284, 286, 289, 290L 291, 298-300,301

obtaining fair value, 294-298 product definition, 270-271 risk-element identification, 267-270 S-curves and, 284-289, 291, 296-298

stock valuation and, 195-197 waterfront approach and, 271

321

Term structure of volatilities, 144, 145, 147,149

Thiagarjan, S., 193 Thinly traded markets, 72, 73 Thompson, W. 1., 7 Thorlacius, A. E., 30 Time, 5, 29 Time discount rate, 129 Time preference, 56-58 Time value of money, 56-58,103-104

defined, 129 entity-specific value and, 104-105

Total discount rate, 60--61 defined, 130

Transamerica, 154, 168, 170, 172,203 Transfer pricing, 136, 139, ]41, 151,

171 Transfer-pricing curve, 139, 151 Transparency, 88, 119 Treasury bonds, 194, 198,213 Treasury rates, 227-228, 231, 232, 242,

244 Treasury spot curve, 139 Treasury spot rates, 233, 236, 240 Treasury yield curve, 142, 144,232,

294,296 Turner, S. H., 7, 11 TVA, see Tax value of assets TV L, see Tax value of liabilities Two-period case, 42-45 Two-sided risk, 94

Uncertainty, 81, 87-88 defined, 130 future cash flow valuation and, 59,

61-63,64 significance of, 75

Unified Valuation System (UVS), 285

Univariate analysis, 203-205, 206t Universal-life-type contracts, 198 Unrealized gains, 201, 202, 203, 205,

206-208,211 UpDn Path, 30, 3lt Upton, w., vii, 105 UpUp Path, 30, 3lt Utility theory, 60, 92

322

Valuation curve, 139, 140 Valuation models, 67-69 Value-at-risk, 93, 300 Value-in-use, see Entity-specific value Vanderhoof, 1. T., 223 Variable insurances and annuities,

98 Volatility

forward, 144-145 future cash flow valuation and, 59,

62, 64 significance of, 76 spot, 145 term structure of, 144, 145, 147, 149

INDEX

Wahlen, J., 191, 193, 195, 202, 208 Wallace, M., 136, 171 Waterfront approach, 271 Weighted average cost of capital

(WACC), 20-21n Weinhoff, S. J. , 7,15 Weston, F. J. , 14 Weston, M., 193, 195 World Markets Model, 183

Yield-curve techniques, 104

Zero-coupon corporate A bonds, 173, 179, 183