Embedded value

Abstract: Strategy, Value, and Risk-The Real Options Approach, by Jamie Rogers, 2002, New York: Palgrave Macmillan In the insurance industry, there are many examples of options to expand and options to abandon. Insurance companies cannot afford to ignore such options. Any serious attempt to valuation of insurance companies now entails a valuation of the embedded and expansion options. In early 2002, the Economist magazine issued a scathing report on the insurance giant AIG. It claimed that by looking at "best in each line of business" and adding them up, the value of AIG should have been less than half of its market value. It claimed that as a result, AIG was severely overvalued. In a strong criticism of the Economist report, Bernstein (http://www.economist.com/finance/aig_bernstein.pdf) showed that the analysis by the consultant hired by the Economist was deeply flawed. The consultants did not take into account the expansion options of the giant AIG. How much would such options be worth? For general insurance and life insurance businesses of the AIG, these options have values approximately equal to their embedded and franchise values. In case of financial products, the real option value was even bigger. In sum, real option value embedded in insurance companies is not little add on. It is one of the main events (see, for a practical application of a real-life takeover valuation using real options, http://allman.rhon.itam.mx/~tapen/ArredondoSinha.PDF). Thus, the use of real options can be quite useful for insurance industry. The professed purpose of this little book is "provide a background to the concept and method of real options." The author, Jamie Rogers is a consultant with PricewaterhouseCoopers, New York with their financial risk management practice. The book is divided into thirteen chapters in four parts. A brief introduction sets the stage. It talks about Schumpeter's thesis of creative destruction. With a brief discussion of value and risk, it launches the case for real options as the value for the flexibility of a project. Part I has four chapters discussing the evolution of strategy, value, and risk. Chapter 1 (of three pages) begins with an overall view about strategy. Chapter 2 gives a four-page summary of net present value. Chapter 3 is an equally brief two-page summary of investment risk. Chapter 4 discusses three strategic case studies: one of information technology, one for energy, and one for the introduction of a new (and expensive) drug by a pharmaceutical company using discounted cash flow analysis. Part II contains three chapters with the general theme of developments in strategy, value, and risk. Chapter 5 discusses strategy in a generic fashion. …

Abstract: Part I: The Intellectual Underpinnings. 1. The Market Value of Insurance Liabilities and the Assumption of Perfect Markets in Valuation L. Girard. 2. The Valuation of Future, Cash Flows S. Gutterman. Part II: Elaboration of Theory and Considerations. 1. Market Valuation of Liabilities: Transfer Pricing, Profit Release, and Credit Spread T. Ho. 2. Fair Value Accounting for Financial Liabilities M. Wallace. 3. Earnings, Historical Cost Book Values, and Fair Value Disclosures in the Valuation of Stock Life Insurance Companies M.L. Michel. Part III: Illustrations of Fair Value Calculations. 1. Modeling Fair Value Financial Reporting Results for the Single Premium Deferred Annuity P. Duran, A.E. Vilms. 2. Considerations for Ascertaining Term Insurance in a Fair Value Context T. Herget. Vita of Contributors.

Abstract: Based on accumulated empirical evidence, the academic community has generally come to agree that value investment strategies, on average, outperform growth investment strategies (Chan and Lakonishok, 2004:71). An influential article by Fama and French (1992) tested the notion that United States stock prices might be related to the ratio of a firm’s book value of common equity (BV) to its market value of common equity (MV). It found that companies with high book value relative to market value of equity (BV/MV) outperform the market. This finding led to extensive testing for the value premium in developed countries around the world. Fama and French (1998a) tested it with data from twelve major European countries, as well as from Australia and the Far East. They found that between 1975 and 1995 in almost every country, value stocks delivered a higher return than growth stocks. The value premium has not been tested with the same vigor in third world or developing countries, which raises the question whether the value premium is only a first world phenomena and, if not, how third world value premiums compare to those found in developed countries. This paper compares the size of the value premium in the USA, UK, and some continental European countries with South African data.