Discounted cashflow model

Hi Tutor,

Below is the summary of how discounted cashflow model works , but there are few parts (Bold) where I am still grappling to develop the thought process. Could you please decode these Bold in easy to understand language :

The intent of the model should be to estimate the market cap of the insurance business, which when divided by the share capital, would give the share price of this unlisted entity. The market cap or company valuation of an insurance company comprises of two distinct parts – existing in-force book as on valuation date and the future new business.

The emergence of future profits, based on expected assumptions and projections, from the in-force book need to be estimated. The discounted value of these cashflows would be one component of value (DCF1). The insurance company would continue to write future new business, on a going concern basis.

For a single block of new business written, emergence of future profits for that block on a standalone basis can be estimated based on expected assumptions and projections, in a manner similar to the one used for estimating the in-force book above. Hence, a standalone DCF model would give the value generated by one cohort of new business (DCFNB).

The future new business would be expected to grow year on year (say at growth rate ‘g’). Assuming same set of assumptions, product mix and business mix, DCFNB could be used as a factor to project the value estimated in future and then discounted to give the second component of value (DCF2), where r is the risk discount rate. DCF2 = DCFNB × (1+g) × (1+r)-1 + DCFNB × (1+g)2 × (1+r)-2 + DCFNB × (1+g)3 × (1+r)-3 + … + DCFNB × (1+g)n × (1+r)-n , with n tending till perpetuity This can be estimated through a sum of an infinite geometric projection, i.e. DFC2 = DCFNB / {1-(1+g)/(1+r)} = DCFNB × (1+r)/(r-g) In case the assumptions vary from year to year resulting in different DCFNB for each future year, a nested set of cashflows could be determined to estimate combined profit emerging in future by writing future new business after the valuation date.

Any adjustments towards tax or opportunity cost of holding regulatory solvency capital or any other encumbered capital requirement, could either be applied as a haircut on the aggregate number or estimated by an enhancement to the above DCF workings.

Sum of DCF1 and DCF2, along with the balance sheet surplus on valuation date, will be the total value of the life insurance business
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Also from above we can understand that the "growth" rate and risk discount rate (r) are two important factor tha t need to be considered as explained below

From the working and formulae in the previous response, it is evident that the critical assumption is growth (g) – greater the growth assumption, greater is the value of future new business and hence the estimated market cap of the insurance company. Further, because of the gearing effect, the gap between growth (g) and risk discount rate (r) would matter significantly. For example, if r = 8% and g = 10%, an increase of an additional 2% in growth rate (which is only 20% greater new business) would have an effect - far in excess of 20% on the company value - because of the gearing effect.