I have noticed that in profit testing there is the allowance for a risk discount rate and a profit margin. I would think that an NPV=0, at a risk discount rate (which is satisfactory for the product) would be sufficient to determine the correct premiums. Why add a profit margin then; does not the risk discount rate cover the required profitability? Thanks Jeff
The risk discount rate reflects the asset allocation and there can be a margin but that's for uncertainty as to what actual levels may be. With pricing estimates all tend to be best estimates + margin sensitivity checks. So you aren't explicitly having a profit margin in an RDR.
What if I know that a company targets 15% return on equity, I'd like to have this as my criterion in the profit test? Can't I just use the 15% as a discount rate and make sure that my NPV is positive (will need to treat the capital requirement associated with the product as a negative cashflow in the profit test)?
my understanding is that you first of all set your RDR based on the SHs required return on capital, based on risk free rate + risk margins etc. You then calculate the premium required at that RDR and other premium basis assumptions to give you the profit that you desire however you have specified it (IRR > 10%, or margin 2% of Prem etc) Setting the NPV = 0 of the profit CFs/initial capital outlay just gives you the IRR of the product/policy. This will vary depending on what premium you charge (assuming prem basis stays the same). ie. The RDR is just the required return, the IRR is the actual return you'd get on that RDR and basis. Anyone have a different view or does this seem reasonable? I may be totally off the mark.
