Can someone explain why a liquidity premium may be added to the risk free rate for discounting future cash flows and setting the expected return that assets earn if an insurer intends to hold corporate bonds to maturity?
Hi The argument goes along the lines: To get a market-consistent value of the liabilities (for which no MV is available), discount the cashflows at the rate available on matching assets. If the liabilities are illiquid (eg no chance of the policyholder surrendering early, so confident will hold bonds to maturity), then they can be matched by illiquid assets. These matching illiquid assets typically have a higher yield (a liquidity premium) than equivalent liquid assets. Hope this helps
