Hello, So I experiencing some confusion surrounding the use of the term cost of capital. (1) In a financial sense, I understand cost of capital as being the required return of shareholders [Which is consequently is in calculations such as WACC to get the total cost of capital]. (2) However, we are now defining cost of capital as the cost of setting up reserves. That is, instead of using the capital provided by shareholders to write new business, it is being used to set up reserves of the existing policies. Since these reserves will be invested in assets possibly earning lower than their required return - this results in a cost. So ultimately does that mean that there are different definitions to cost of capital? Additionally, in a make belief world where insurers are not required to hold any reserves, if all the shareholder capital is used to finance new business (handle the new business strain) - does this then mean that there is no cost of capital since there are no reserves and shareholders will receive their required return from financing the new business? [Based on definition (2) of cost of capital] Thanks in advance.
Hello Thank you for your question. Cost of capital is a difficult area as there are many different ways to look at as you've noted above. First of all I'd like to differentiate between a cost of capital rate (say 6%) and the cost of capital (say $12 million). But often cost of capital is used in a very loose way to indicate that providing capital carries a cost. We can calculate the cost of capital in a particular year by multiplying the required capital by the cost of capital rate. So if the insurer is required to have $200 million of capital and the cost of capital rate is 6%, then the cost of capital is 200 x 0.06 = 12 million. There are many ways that the cost of capital rate may be calculated. For example it may be the excess of the shareholders required return over the actual return, with the required return based on the WACC as you suggest. So if assets earn 2% and the WACC is 8% then the cost of capital is 6%. There are many different definitions of required capital. A common approach for SP2 would be to look at the reserves and solvency capital requirements in excess of the asset share. So if the reserves are $300 million and the solvency capital requirement is $50 million, but the asset share is only $150 million, then the insurer is required to provide capital funding of 300 + 50 - 150 = $200 million. I reserves were zero, there could still be a cost of capital. For example the asset share may be negative if the initial expenses are larger than the initial premium. Best wishes Mark
