Unbelievable Risk Discounts Rates

Setting discount rates is a crucial and subjective exercise. This is true for life insurance embedded values too.

Many researchers are comfortable with a range for Equity Risk Premiums of between 3% and 5%. Many corporate finance practitioners use a range from 5% to 8% or even higher. My nearly eight-year-old blog post on mis-estimating the ERP covered these differences in detail.

This post is a little different. Forget about what theory says, what are the implications of using a high risk discount rate (RDR) when calculating embedded values and then trying to maximise value.

Solvency II and SAM suggest a 6% (excess over risk-free) cost of non hedgeable capital. Most South African insurers calculating real-world embedded values use risk-free + 3.5% as their RDR.

Some insurers want to use an RDR closer to 15% or even 20%. The problem here is one of conviction. If the cost of capital was truly felt to be 20%, then capital optimisation, value optimisation and therefore reinsurance decisions should be made with this in mind.

It will almost always be the case that reinsurance will have an implied cost of less than 20%. Thus, the consistent action would be to grab as much reinsurance as possible, at least up the point where the reinsurer was concerned about skin in the game.

I don’t see this happening in practice.

Some insurer will argue that they don’t want to give away all their profits to a reinsurer. This fundamentally misunderstands how reinsurance is priced and the impact of return and profit commissions to facilitate reasonable commercial terms.

Similarly, the pursuit of greater investment returns usually results in more risk and more capital required. At a 20% return on capital requirement, pretty much no avoidable market risk should be retained. Yet I still see insurers opting to take on more credit risk (even at current depressed credit spreads) in pursuit of a little extra yield.

We can have a debate about the range of reasonable RDRs to use. But there is a credibility problem if this rate isn’t also used to decide on reinsurance and investment strategies.

Published by David Kirk

The opinions expressed on this site are those of the author and other commenters and are not necessarily those of his employer or any other organisation. David Kirk runs Milliman’s actuarial consulting practice in Africa. He is an actuary and is the creator of New Business Margin on Revenue. He specialises in risk and capital management, regulatory change and insurance strategy . He also has extensive experience in embedded value reporting, insurance-related IFRS and share option valuation.

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