what is the cost of holding capital? I know we say it's the opportunity cost to the investor if investing in an insurance company compared to elsewhere on the market. Effectively is the actual investment return achieved in reserves compared to the assumed discount rate used to value liabilities?
To some extent, yes. The Cost of Capital is the opportunity cost of having to hold on to the capital in a more liquid form (such as cash) rather than being able to invest and earn a decent rate of investment.
The phrases "cost of capital" and "frictional cost of capital" can be used interchangeably, although sometimes the phrase "frictional cost" is used to refer to the subset of "cost of capital" that relates to tangible costs such as additional taxation incurred by shareholders through having capital locked into an insurance company. As Naimin has suggested, cost of capital can be thought of as the opportunity cost: benefits foregone through locking capital into a company where it may be invested in assets with potentially low returns, rather than being able to use it more freely to gain higher returns. It can be thought of as the cost of raising incremental capital in excess of the risk-free rate (as noted elsewhere in the Core Reading - see Chapter 12 Section 2.2). It can be thought of in terms of the frictional costs that eat away at the value of the locked-in capital, such as any additional taxation as noted above, or due to "agency costs" (destruction of value due to poor management decisions) - as noted in Chapter 19 Section 3.3. Or it can be thought of as just 6% pa, if considering Solvency II!
