What is the cost of capital rate is it either: 1. The rate of return required by shareholders if they invested the capital freely? 2. The shareholder's rate of return in excess of the risk-free rate of return? For example: Shareholders can get a return of 10% from investing freely in equities. The risk-free rate of return is 2%. Is the cost of capital rate 10% or 8%?
It depends on context. The 'cost of capital' can be thought of as the shareholders' required rate of return from their capital investment, or as the cost for a company of raising incremental capital (both debt and equity). So in your example above, 10% pa. If we are talking about the 'cost of capital rate' that is used to determine the risk margin under Solvency II, then (as stated in the Core Reading - see Chapter 11 Section 2.2) one interpretation of the 6% pa 'cost of capital rate' parameter is that it can be considered to represent the cost of raising capital in excess of the risk-free rate. In your example, that would be 8% pa.
Thank you for clearing that up. 1. When you say shareholder's required rate of return - does this include both the income component and capital gain? 2. So for example if the shareholders alternatively invested freely in other equities (other than the insurance company), then their required rate of return would equal both dividends received and any share price gain?
Yes, it would be based on total return (income and capital gains) and yes, it would be informed by returns achievable elsewhere, but it's important to remember that the 'required return' for a particular investment proposition will reflect the degree of risk of that proposition. I would recommend checking back at your CA1 / CP1 notes where you will find the definition of 'required return' (broadly = risk-free rate + additional risk premium). A shareholder investing capital into a risky, niche life insurance company (say) would probably want a higher return than one investing in a very stable blue-chip company.
