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Embedded Value and Cost of Capital

Discussion in 'SP2' started by Sayantani, Mar 10, 2022.

  1. Sayantani

    Sayantani Very Active Member

    hi,
    I had a query regarding the cost of capital in the embedded value calculation in Setting Assumptions(2) -Pg8.
    the numerical says that "For example if there were no cost of capital-which would be the case if shareholder's required rate of return was equal to 6% they could get from their invested reserves - then the embedded value profit would be 7.91 + 2.91/1.06 = 10.66"
    I am not able to understand the relevance of cost of capital here. I thought the cost of capital is the cost to shareholders of deferring their profits due to holding reserves. so for example if reserves grow at 10% but shareholders required return is 12%, then 2% is the cost of capital.
    Why would we change the risk discount rate to 6% to explain the cost of capital? Or is it because we are comparing this against the best estimate valuation approach? sorry a bit confused here.
     
    Sayantani, Mar 10, 2022
    #1
  2. Mark Willder

    Mark Willder ActEd Tutor Staff Member

    Hi Sayantani

    Yes if reserves grow at 10% but shareholders required return is 12%, then 2% is the cost of capital.

    So all we are saying in the notes (in the bit in brackets) is that if reserves grow at 6% and the required return is 6% then there is no cost of capital.

    However the example (the main bit that is not in brackets) demonstrates that when the required return is 10% (and reserves grow at 6%) we do have a cost of capital, because the EV is only 10.56, while the realistic profit calculation gave 10.66.

    I hope this helps.

    Best wishes

    Mark
     
    Mark Willder, Mar 10, 2022
    #2
  3. Sayantani

    Sayantani Very Active Member

    Yes that makes sense.
    Thanks Mark.
     
    Sayantani, Mar 10, 2022
    #3
  4. Sayantani

    Sayantani Very Active Member

    Hi Mark,
    There is another thing which I am slightly getting confused about it is:
    We are saying here that reserves are growing at 6% which is what we have assumed on best estimate basis whereas the supervisory reserving basis is 3%. So there is a difference between the value at which we are projecting the reserves and the supervisory reserving basis because we are not using the supervisory basis for projecting as I understand the interest earned on reserves will be part of the asset so using the realistic projection rate. Is my thinking correct?

    My second point is when we calculate the embedded value for example for without-profits, the PVFP component consists of (Premiums + Investment Return -Claims -Expenses)+ Interest on Reserves + Release in Reserves.
    I am referring to Pg 15 of Models(2) where the example shown calculates the embedded value.
    Will then the investment return percentage on assets( the part in brackets above) and the interest on reserves be different?
     
    Sayantani, Mar 14, 2022
    #4
  5. Mark Willder

    Mark Willder ActEd Tutor Staff Member

    Hi Sayantani

    Yes, you're thinking in the first paragraph is correct. We calculate the reserve using the valuation interest rate of 3%, but we project the interest in the profit formula at the projection basis rate of 6%. It doesn't matter what we are projecting (interest on the cashflows or interest on reserves) we will always project on the projection basis of 6%.

    The easiest way to remember it is that the valuation basis is used only to calculate the reserves (this is true of all basis items, investment, mortality etc) so we have the start and end year reserves. Everything else is calculated using the EV projection basis.

    Best wishes

    Mark
     
    Mark Willder, Mar 14, 2022
    #5

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