Hi, I have learnt that if cost of finance increases, insurance company is likely to increase discount rate for provision of its liabilities. Why is this so?
I think the answer to this question depends on the context. Please can you let me know where you have seen this (eg which part of the notes or past question). Best wishes Mark
Is it because when cost of finance increases, borrowing becomes more expensive - hence the insurance company will want to borrow less / need less capital -> hence they want to use higher discount rate so to reduce provision and hence capital required and therefore lower borrowing?
No, I don't think this is the correct reason. The regulator wouldn't be very happy if the insurer attempted to reduce reserves in this way. The key thing to note in this question is that the increase in the cost of finance has affected the whole economy. So it is more expensive for companies to borrow. One of the main ways that companies borrow is by issuing corporate bonds - these bonds will now have to have a higher yield (ie borrowing is now more expensive). Insurance companies invest in corporate bonds. So their investments will have a higher yield (and lower price). Hence we can use a higher yield when discounting our liabilities. Best wishes Mark
