Chapter 17: Assumptions (4)

Question 1

What should the risk discount rate reflect?

Answer 1

Reflect the combination of (1) and (2) below

(1) rate of return required by the shareholders

Sum of the risk-free rate of return and risk premium to compensate the shareholder for investing in the company
The risk premium may be determined using CAPM

(2) Level of statistical risk attaching to the cashflows under consideration

factors that influence the riskiness of products (when viewed as an investment):
lack of historical data
onerousness guarantees
policyholder options
high overhead costs
complexity of design
untested market

The level of statistical risk can be assessed:
analytically by considering the variances of the individual parameters
using sensitivity analysis with deterministic variations in parameters
using stochastic modelling (for some or all of the parameters) and simulation
by comparison with available market data