Pricing Insurance Contracts Following the Cost of Capital Approach: Some Conceptual Issues

Posted: 25 May 2009

See all articles by Alberto Floreani

Alberto Floreani

Catholic University of the Sacred Heart of Milan - Department of Economics and Business Administration

Date Written: May 1, 2009

Abstract

The Solvency II directive requires that all assets and liabilities follow a market consistent valuation. The part of insurance liabilities that cannot be valued using market prices (the non-hedgeable liabilities) is split into a best estimate (the discounted value of the current estimate of all future cash flows following from the insurance liabilities) and a risk margin (Ceiops-Sec-82-08). The risk margin should be estimated using the cost of capital approach, i.e. the cost of solvency capital requirement - which is computed through a value at risk measure - needed to support the insurance obligation until settlement. In addition, the unitary cost of capital applied to the future capital requirement is fixed.

This paper deals with conceptual issues relating to the risk margin estimate through the cost of capital approach. The main points that emerge are briefly summarized hereunder. Either an indirect approach based on observable insurance equity price and shareholders' expected rate of return or a direct approach based on insurance contract characteristics are both consistent with financial economics and are perfectly equivalent theoretically. However, only by using a direct approach does the risk margin estimation seem practically implementable.

The Solvency II specification of the methodology is also consistent with financial economics. However, the theoretical framework required (a frictionless and normally distributed world) is too far-fetched to be acceptable. In addition, even if these conditions were satisfied, a variable unitary cost of capital would be needed.

A consistent risk margin estimate requires the identification of priced risks in insurance contracts, i.e. the risks which affect the expected return of insurance contracts. Non-hedgeable systematic risks seem to be the most relevant, however non-hedgeable and non-systematic priced risks could also be important, but should be treated separately from systematic risks. The risk margin could also consider expected frictional costs, if they are not explicitly computed in the best estimate. In this framework more than one risk measure should be used in the risk margin estimation. Under no condition does the value at risk measure seem to be a viable candidate.

This paper is currently reserved to Carefin sponsors and will be made public on SSRN after a short embargo. Please visit the CAREFIN website to learn more on how to get the paper.

Keywords: Insurance contracts, Fair value, Risk margin, Market frictions, International accounting standard (IAS)/International Financial Reporting Standard (IFRS), Solvency II

JEL Classification: G12, G13, G22, G28, M41

Suggested Citation

Floreani, Alberto, Pricing Insurance Contracts Following the Cost of Capital Approach: Some Conceptual Issues (May 1, 2009). CAREFIN Research Paper No. 9/09, Available at SSRN: https://ssrn.com/abstract=1409551

Alberto Floreani (Contact Author)

Catholic University of the Sacred Heart of Milan - Department of Economics and Business Administration ( email )

20123 Milano
Italy
0272342983 (Phone)

Do you have negative results from your research you’d like to share?

Paper statistics

Abstract Views
1,337
PlumX Metrics