Cost of capital

Discussion in 'SA1' started by mossie, Sep 21, 2017.

  1. mossie

    mossie Active Member


    Could someone please explain how CoC is allowed for in a cashflow projection? Do you allow for the CoC for just the SCR, or TP+SCR?


  2. Sarah Byrne

    Sarah Byrne ActEd Tutor Staff Member

    The cost of capital is defined in Chapter 13. It is applied to the "projected capital requirement" which is a subset of the SCR representing the capital required to be held against risks that can't be hedged in financial markets.

  3. mossie

    mossie Active Member

    Thanks Sarah.

    Did you mean the CoC = risk margin (RM)?

    In the chapter 8 summary, it saids 'Cost of capital is the loss of return on shareholders' investments resulting from holding reserves'. Would you interpret the 'reserve' (underlined) as the SCR relating to non-hedgeable risks, or SCR, or SCR+RM, or SCR+TP?

    This is confusing to me - the CoC is essentially the opportunity cost of holding reserves. Why would you restrict measuring the opportunity cost to only the SCR relating to non-hedgeable risks? Since you need to hold reserve to cover the full TP+SCR.

    Going back to my original question: how do you allow for CoC in a cashflow projection. If as you suggest, CoC is essentially the RM, does it mean it is allowed for in the 'change in reserve' item in the projection? (where reserve = BEL+RM+SCR)

    Sorry for the long-winded question, but I hope it explains what I am confused about.

    Many thanks!
  4. Sarah Byrne

    Sarah Byrne ActEd Tutor Staff Member

    I think we might have been talking at cross-purposes here!

    Chapter 8 about general "cost of capital" whereas when we talk about Solvency II we use the "cost of capital approach" to determine the risk margin.

    So, in Chapter 8, this is a more general chapter and in this context, the cost of capital from holding reserves could be any capital that has to be set aside.

    In Solvency II, we are determining the risk margin and so just apply the cost of capital to the non-hedgeable cashflows from the SCR calculation. We do this because this is how the SII regulations require it to be calculated!

    More generally, you could allow for the cost of holding capital in a similar way. So, work out the capital (using any definition you decide, if we're using SII it could be SCR + BEL + RM as you suggest) required each year and then the "cost" of holding this is a proportion of the amount required.

    Hope this clears up the confusion!

  5. mossie

    mossie Active Member

    Thanks Sarah! Yes I was more interested in the general context of CoC.

    About your last paragraph - I never seem to see CoC being included in cashflow projections (when mentioned in course notes or exam solutions), other than general comments that it should be allowed for.

    For e.g. NPV of a policy = PV of future "Premiums - Claims + Investment income - Expenses - increase in reserve",
    In which cashflow item would CoC typically be included?
  6. Sarah Byrne

    Sarah Byrne ActEd Tutor Staff Member

    We often mention "solvency capital" within of a cashflow projection and I would say this includes any required cost of capital.
  7. mossie

    mossie Active Member

    Under SII, is it the 'risk margin' component that allows for the CoC? I cannot see where in the calculation of the SCR (under Standard Formula) where the CoC would be allowed for.

    In Ch11, p6, first bullet point (below) talked about all the cashflows that should be allowed for, but it didn't mention CoC. Why is that? If it should be allowed for, would it be a physically real, or notional cashflow?

    A model also needs to allow, where appropriate, for the cashflows arising from any supervisory requirement to hold reserves and to maintain an adequate margin of solvency.

    Here we can distinguish between what the company might refer to as physically real cashflows, and notional cashflows.

    The real cashflows include: premiums and investment income as positives; payments to policyholders, commission to agents, expenses and tax as negatives. These should all have been included as items of cashflow (from the first bullet point!).

    If there is a supervisory requirement to hold reserves (which there almost always is!) then the insurance company will need to fund the establishment of these reserves. Similarly, at maturity or earlier claim, reserves may need to be released. In addition, there might be a requirement to hold solvency capital, ie an additional layer of capital over and above the supervisory reserves. These flows are examples of notional cashflow, ie where the flow does not involve a physical exchange of money.
  8. Sarah Byrne

    Sarah Byrne ActEd Tutor Staff Member

    The risk margin under Solvency II is determined using a cost of capital approach.

    It would be a notional cashflow. The material you have quoted here is from ST1 so relevant, but not identical, to SA1 where there is more detail on capital requirements under SII.


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