Cost of Capital

‘Cost-of-capital’ is the name of a method used to establish the full economic value of insurers’ liabilities where there is no ‘market price’ which can be used to establish their value.   

Without a market to compare against, the cost of capital approach looks instead at the amount of risk-capital an insurer needs in order to manage and run-off their liability. This approach has been pioneered in Switzerland, (and is known there as the Swiss Solvency Test). The idea is that an insurer makes their ‘best estimate’ of the cost of claims that will arise from a given set of insurance liabilities. The insurer must also hold capital to provide a buffer against volatility and uncertainty in this ‘best estimate’. Holding this capital has a cost, an interest cost. Once the amount of risk-capital needed for a given set of liabilities has been calculated, an interest cost can be derived, based on the length of time over which the liabilities will be run off (the period over which claims may be expected). This cost is discounted and then added on top of the basic ‘best estimate’, to give a more accurate assessment of the total cost of meeting the specified liabilities.