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Risk discount rate RDR

D

dChetty

Member
The notes say that RDR is the return required by the shareholders on the capital they invest in the insurance company. Please explain with numerical example. Do shareholders decide on the RDR to use to discount the profits of the company? Why do shareholders demand a higher risk discount rate if that reduces the present value of profits?
 
dChetty said:
The notes say that RDR is the return required by the shareholders on the capital they invest in the insurance company. Please explain with numerical example. Do shareholders decide on the RDR to use to discount the profits of the company? Why do shareholders demand a higher risk discount rate if that reduces the present value of profits?
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Shareholders do not determine the RDR directly as there are too many of them. However, the Board of Directors will determine the RDR on their behalf. The Board will then make decisions based on the RDR.

A guaranteed cashflow of 100 in one year's time is worth more than a risky cashflow of 100 in one year's time. So by using a higher RDR on the risky cashflow, we obtain a lower net present value, which tells the Board that the risky cashflow is less desirable.

In the above example it's obvious which cashflow is better, but consider the following simple examples (all cashflows are at time 1 for simplicity).

The insurer can sell a low risk product offering 100, or a higher risk product offering 105. Both products require the same initial injection of capital. The higher risk product is better in the sense that it gives a higher profit, but is worse in the sense that it is more risky. So which to choose.

Imagine that the RDR for low risk contracts is 4% and for high risk contracts is 10%. This is the same concept as saying we'd require a higher return on risky assets such as equities as opposed to bonds. The low risk contract has net present value 100/1.04=96.15. The high risk contract has net present value 105/1.1=95.45. In this case the Board should sell the low risk contract as it has the higher net present value.

I hope this example helps.

Mark
 
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