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Draft for discussion at ICAEW IISC meeting, 20th June 2005 - page 33 / 51





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Our overall review comment: For the reasons discussed in Horton & Macve (1995) (see section 4.a) above) we reject this paper’s conclusion (and that of O’Brien, 1994), that the ‘earned profits’ method is the only ‘realistic’ method that can comply with the Companies Act.

d) Klumpes, 2005 ‘Managerial use of discounted cash-flow or accounting

performance measures: evidence from the UK life insurance industry’ This paper surveys the relevance of EV based methodologies to CEOs for strategic planning and control purposes and seeks to identify the company characteristics that differentiates those who utilise them. Proprietary companies are found to be more likely to adopt them than mutuals. Our overall review comment: Given the restructurings and demutualisations within the industry in recent years the conclusions give limited insight. In particular, ‘embedded value’ in the UK largely originated with the Pearl takeover by AMP (Salmon & Fine, 1991) and anecdotal evidence suggests that potential ‘target’ mutuals have given increasing attention to estimating their EVs and attending to their own performance in the light of these. The author acknowledges these limitations on the paper’s results..

5. The actuarial profession The recent papers reviewed here all focus on ‘fair values’ and ‘embedded values’. The Forfar and Masters paper appears to leave the final decision on how fair values should be measured to the accountants: i.e. what consequent pattern of profit emergence is acceptable. The later papers focus on the developing debate over the ‘shortcomings’ of traditional EV methods, the advances made in the EEV principles, and the increasing focus on ‘MCEV’ methodology.

The MCEV debate has been conducted in the context of the application of modern finance theory to insurance companies. But the theory is equally applicable to the valuation of all companies: a major implication for the accounting profession and standard setters must therefore be how far they also need to master the theory if they are to make progress in understanding the meaning and applicability of ‘fair value’ in the context of accounting for the generality of businesses (including inter alia their investments, defined-benefit pension obligations, and outstanding stock-options).

In some respects the actuaries’ own explication of the theory and of ‘economic balance sheets’ itself needs further analysis and caution against the risk of double counting of various elements. For example, they would debate whether to recognise as part of a company’s overall valuation the value of the “shareholders’ put option” under limited liability.65 But given the basic ‘Modigliani-Miller’ theorem that, at least in ‘perfect and complete’ (and tax-free) markets, capital structure cannot alter the value of the firm as a whole, any additional value to shareholders from limited liability must be offset by an equal loss to debt-holders/creditors—in other words it should already be reflected in the market value of debt and other liabilities as ‘credit risk’. Again, structural tax effects may already be reflected in those valuations (e.g. through proper ‘economic’ deferred tax accounting). Considerable work remains to be done here.


(e.g. O’Keefe et al., 2005, B.3)


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