Discounting Net Cashflows

[Sid Dagore]

The core reading in Chapter 16 says that an appropriate risk discount rate should be applied to the net cash flows in order to get a NPV. It also says that theoretically this rate should differ in accordance with the level of statistical risk attaching to each cash flow.

So that means that the risk component of the RDR(where the RDR = ROR required by the company + risk premium) should be altered depending on how risky the cash flow is.

This only seems to make sense to me in the context of a positive net cash flow, when the company is trying to derive the fair npv of that cash flow - if it is more risky then it should be worth less now meaning that we increase the RDR.

So what do we do with a negative net cash flow, 5 years into a contracts life, say. We will probably want to make it worth more now , so we will have a negative risk premium?!?!?!?! What on earth does that mean?

Relatedly, the core reading in chapter 18 says we can't use this approach in formula pricing, only in cash flow pricing. Why not - just use a different, lower rate to price the liability function and a higher one for the premium discounting?

Thanks very much!

 

[SpringbokSupporter]

If you look at a typical profit testing example - there will be an initial negative net cashflows and then positive net cashflows after that. This is because the net cashflow contains a change in reserve item which will sort of smooth profits. The RDR would then be applied on this positive net cashflows...

Even with the example of a single premium policy, if we don't include reserves there will be a initial positive cashflow and then negative cashflows afterwards. But if you include the change in reserve item, you will see that there is gonna be negative initial net-cashflow and then positive net cashflows thereafter...