Hi, From Chapter 17 Page 22, regarding the margin in the discount rate, "The company will now make less profit than it requires if i is sufficiently low that the return on capital is less than the required rate of return." Could someone please provide further explanation on the above sentence please.
In the case that you refer to, the contract is being priced with best estimate assumptions. So we are not expecting any contribution to profit from the mortality experience, expense experience etc. The premium is set so that the future profits, discounted at the risk discount rate i, meet some profit target, eg a net present value of 100. Let's say i is 6%, but the shareholders require a return on their capital of 8%. Then the profit made on this contract won't be enough to satisfy the required rate of return of 8%. The shareholders will only be making 6%. Best wishes Mark
Hi Mark, Thank you for the reply. I still have a question. How does reducing the shareholders' return in this case provide for margins against adverse experience?
You have this the wrong way around. We take a margin for adverse experience by having a large risk discount rate. The larger the risk discount rate used, the larger the return that the shareholders get as compensation for the risk they have taken on. The part of the notes that you referred to was explaining the risk that if we used a risk discount rate i that was too low, then the shareholders wouldn't be getting a sufficient return. Hence in my example the shareholders were losing out because they wanted 8%, but we'd only priced for 6%. Best wishes Mark
