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It's about value and measurement: valuation models should focus on the firm as a going concern.

Nearly every chief executive officer will claim that his goal is to maximize the value of his firm to its owners. The paradox is that many CEOs have no reliable measure of their firm's value and the potential effect on that value of alternative choices, past or future. Lacking such a measure makes it difficult to effectively manage the firm's value.

The remedy is an internal model that reflects crucial features of the firm's business and estimates the resulting value of the firm.

Although model details will vary by firm, some major features are crucial.

First, a valuation model should focus on the value of the firm as a going concern rather than on its liquidation value. Liquidation value roughly consists of a firm's net worth less the transaction and other costs of selling its assets and paying off its liabilities. It is the amount that one expects to be left over from a going-out-of-business sale.

Going concern value, by contrast, is an estimate of the present value of the firm's future earnings under a variety of scenarios that faithfully reflect risks to the viability of the firm's business.

Second, a valuation model should incorporate realistic risks. For example, going concern value would take into account scenarios in which a long-tail casualty insurer would be downgraded to a rating that undermined client confidence in its ability to pay claims in the distant future. But such a model would also take into account actions that the firm might take--such as increasing surplus or purchasing reinsurance--that would lower the probability of such undesirable consequences. Incorporating risks and remedies stands in contrast to many corporate planning exercises that emphasize single scenarios and targeted outcomes, with little attention to what might go wrong.

Third, a useful valuation model should enable a firm to estimate the consequences of specific actions. Typically at stake are options that involve incurring near-term costs in return for greater but uncertain future benefits. For example, a firm that directly marketed personal lines insurance used such a model to consider whether it should establish a premium discount for policyholders that had been with the firm for five or more years. Their valuation model indicated that doing so would add substantially to the firm's value as a going concern, since the near-term loss of premium revenue would be (and in fact was) far outweighed by increased future revenues from higher policy renewal rates.

Another model, applied to numerous client firms, enables them to determine whether the current-year cost of alternative reinsurance programs is offset by an increase in their going concern value--a factor typically ignored in simplistic single-year analyses.

Valuation raises complex issues that cannot be explained or resolved in a few paragraphs. But the basic principles are easily stated: To maximize value, create and use a valuation model that focuses on the firm as a going concern, that incorporates realistic risks and that has sufficient detail to enable estimates of the value added or subtracted by specific actions.

William H. Panning, a Best's Review columnist, is executive vice president at Willis Re Inc. He can be reached at bill.panning@Willis.com.
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Title Annotation:Property/Casualty: Loss/Risk Management Insight
Author:Panning, William H.
Publication:Best's Review
Geographic Code:1USA
Date:Apr 1, 2010
Words:521
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