Risk Discount Rate vs Discount Rate

Discussion in 'SP2' started by BrainGame, Mar 17, 2019.

  1. BrainGame

    BrainGame Member

    Hi ,

    I have a doubt regarding Difference between RDR and Discount rate?

    1. As per my understanding, RDR = Risk Free Rate + Risk Premium(Based on CAPM model or any other technique), while investment return is based o the expected return on assets. Investment return is further used to decide the discount rate used to discount Reserves. I am still doubtful about the use of RDR and Discount rate based on Investment return? As per my understanding, RDR is used to discount profit in Pricing while Discount rate is used to discount CashFlows in Reserve calculation? Can you please confirm my understanding and provide more details about it.


    2. What is significance of IRR and NPV if we base pricing on RDR?

    3. Question 20.2 of 2018 syllabus of ST2 stats that "
    The risk discount rate is a measure of the return that the shareholders require on their capital, it has nothing to do with the return that the company can earn on its assets, and hence is irrelevant to a calculation of the reserves."

    Can you please provide your comments? Why it is irrelevant?
     
    Last edited by a moderator: Mar 17, 2019
  2. BrainGame

    BrainGame Member

    Can please someone reply on urgent basis???
    Thanks in advance!
     
  3. Muppet

    Muppet Member

    I'll throw in one thing:
    The RDR is used to discount future profits, eg when calculating an EV or in pricing. If we want to be more prudent, we would use a higher RDR to give a lower PV of profits.
    In most reserving calculations, to be prudent we would choose a lower interest rate, to end up with a higher reserve. The rates are being used for different purposes.
     
  4. jon93

    jon93 Member

    Yeah - and isn't the difference also that:

    When we are discounting future profits, we want to assess what their current value is from the shareholders' perspective - so we will do it using their required rate of return allowing for risk

    When we are discounting future liabilities, we want to know how much money we have to hold now in order to have enough to pay for those liabilities (net of any future premium income) when they arise - so we do it using the rate of investment return that we will earn on the assets held now

    So we are doing different things

    You need an RDR in order to calculate the NPV (= net present value of future profit cashflows)

    And the IRR is just the RDR that solves to give NPV = 0. So I guess you would need to ensure that the IRR is at least as great as the shareholders' required rate of return?
     
    Muppet likes this.
  5. Adam

    Adam Member

    Thank you for the above discussion. They all make sense to me. However, I am still confused about one thing.
    RDR is what shareholders expect to earn. This number is usually around 10-12% across jurisdictions. However, it is also the case that insurers usually have quite modest investment return, say 5%. Then why on earth the shareholders would expect to earn 10-12% when in fact they can only earn 5%?

    Thank you!
     
  6. Lindsay Smitherman

    Lindsay Smitherman ActEd Tutor Staff Member

    The risk discount rate is what the shareholders require from their investment, allowing for the inherent risk. If we are pricing a new product, say, then the risk discount rate should reflect the return that the shareholders require from investing their capital in this new product. There will be considerable risks involved in launching a new product, both in terms of setting suitable assumptions for the pricing and in terms of the potential success (or otherwise) of the launch. Hence the shareholders will require a high risk premium and therefore high overall return on capital - thus a high risk discount rate in the pricing.

    This is covered in Section 1.8 of Chapter 17, including a list of the types of product features which would likely lead to a higher risk margin.

    If we are considering the investment return earned by an insurance company, then this will reflect the mix of assets in which the company's assets are invested - much of which could be in relatively safe assets such as government bonds. Hence the difference.

    [Having said that, the discount rates that you quote seems quite high - I would have expected to see figures like that about 10-15 years ago, but lower now that we are in a lower interest rate environment globally. But it does, of course, depend on the risks inherent on what is being assessed.]
     

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