Hello,
In the notes, it states that if the actual reserves are set up more prudently than the reserves used for pricing, then there will be a higher cost of capital. I am unsure of why the cost of capital would be higher. Also, based on previous notes, if the investment income and the RDR are the same, then any change in reserves will not change profit. If this is true, are we assuming that the investment income and RDR aren't the same for the note in Chapt 18?
Thanks much.
Hi JamaicanJem
Thanks for your question. This is quite a technical one.
In Chapter 17 Section 1.8 the notes describe two different approaches to the discount rate. The first is the use of risk discount rates, and the second is the use of a market-consistent valuation.
I think you were thinking of a market-consistent valuation where the interest rate and discount rate would both be based on the risk-free rate, and so could be the same. Market-consistent valuations are associated with a best estimate calculation of reserves, with a separate calculation for required capital to introduce an element of prudence. The cost of capital could then be calculated using a risk margin as described in Section 2.3 of Chapter 20.
However, the quotation you make from Chapter 18 Section 3.1 talks about reserves being calculated on a prudent basis, so this is not a market-consistent calculation. So instead the discount rate will be a risk discount rate and so will not be the same as the investment return. The reserves are likely to be backed by safe assets such as government bonds earning a low rate of return. While the risk discount rate will be higher reflecting the risk of the business, see the Core Reading in Chapter 15 which states
"The net projected cashflows will then be discounted at a rate of interest, the
risk discount rate, which is discussed further in Chapter 17. It may, for example, take into account:
· the return required by the company, and
· the level of statistical risk attaching to the cashflows under the contract,
ie their variation about the mean as represented by the cashflows themselves."
So in Chapter 18 we can see that making the reserves more prudent will increase the reserves. These reserves will only grow at the return on government bonds, say 2%. But the risk discount rate reflects the shareholders required return for risky business, say 8%. So there is a cost of capital of 6%. The higher the reserves, the higher this cost.
The situation wouldn't actually be so very different if we used a market-consistent valuation except that the we would be increasing the required capital rather than the prudence in the reserves. Then using the equation on page 9 of Chapter 20 and a cost of capital charge of k_t=6% we get a similar result, ie bigger reserves or bigger required capital leads to greater cost of capital.
Sorry, this is quite a technical answer. In summary, it's worth being aware that there are two separate approaches. The traditional approach is associated with prudent reserves ans risk discount rates. While the market-consistent approach is associated with best estimate reserves, additional required capital and risk margins. It won't always be explicitly stated which of these approaches are being used, but you'll be able to work it out from the ideas associated with each.
I hope that helps, but do let me know if you have further questions.
Best wishes
Mark
