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Relevancy of the cost-of-capital rate for the insurance companies

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Abstract

For many assets and liabilities there exist deep and liquid markets so that the market value are reasily observed. However, for non-hedgeable risks, the market value of liabilities must be estimated. The Draft Solvency II Directive suggests in article 75 that the valuation of technical provisions (for non hedgeable risks) shall be the sum of a best estimate and a market value margin measuring the cost of risk. The market value margin is calculated as the present value of the cost of holding the solvency capital requirement for non-hedgeable risks during the whole run-off period of the in-force portfolio. One of the majour input of the market value margin is the cost-of-capital rate which corresponds to the risk premium applied on each unit of risk. According to European Commission (2007), European insurance and Reinsurance Federation (2008), and Chief Risk Officer Forum (2008), a single cost-of-capital rate shall be used by all insurance undertakings and for all lines of business. This paper aims at analyzing the cost-of-capital rate given by European Insurance and Reinsurance Federation (2008), and Chief Risk Officer Forum (2008). In particular, we highlight that it is very difficult to assess a cost-of- capital rate by using either the frictional cost approach or the full industry information beta methodology. Nevertheless, we highlight also that it seems to be irrelevant to use only one risk premium or all the risks and all the companies. We show that risk is not characterized by a fixed prices. In fact, the price of risk depends on the basket of risks at which it belongs, the risk level considered and the time period.

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File URL: ftp://mse.univ-paris1.fr/pub/mse/CES2008/B08094.pdf
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Paper provided by Université Panthéon-Sorbonne (Paris 1), Centre d'Economie de la Sorbonne in its series Documents de travail du Centre d'Economie de la Sorbonne with number b08094.

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Length: 24 pages
Date of creation: Nov 2008
Date of revision:
Handle: RePEc:mse:cesdoc:b08094

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Keywords: Market value margin; cost-of-capital rate; diversification effect; risk level.;

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