PlumBot: Bot: Creating new article from JSON

2026-03-16T11:50:41Z

Bot: Creating new article from JSON

New page

📐 '''Cost of capital method''' is a valuation and reserving technique used in insurance to quantify the [[Definition:Risk margin | risk margin]] — the additional amount, over and above the [[Definition:Best estimate liability | best estimate of liabilities]], that a rational [[Definition:Insurance carrier | insurer]] would require as compensation for bearing the uncertainty inherent in those obligations. The method is most closely associated with [[Definition:Solvency II | Solvency II]], where it serves as the prescribed approach for calculating the risk margin component of [[Definition:Technical provisions | technical provisions]], but variants appear in [[Definition:Swiss Solvency Test (SST) | Switzerland's SST]], in the Bermuda regulatory framework under the [[Definition:Bermuda Monetary Authority (BMA) | BMA]], and in actuarial practice more broadly when determining the [[Definition:Fair value | fair value]] of insurance liabilities for transactions or financial reporting.

⚙️ Under Solvency II, the cost of capital method works by projecting the [[Definition:Solvency capital requirement (SCR) | solvency capital requirement]] that a hypothetical entity — one that assumes the insurer's obligations — would need to hold in each future year until all liabilities are settled. A fixed cost-of-capital rate (set by [[Definition:European Insurance and Occupational Pensions Authority (EIOPA) | EIOPA]] at 6% per annum, though periodically debated in regulatory reviews) is then applied to each year's projected SCR, and the resulting stream of annual costs is [[Definition:Discounting | discounted]] back to the valuation date. The sum of those discounted costs is the risk margin. In practice, projecting future SCRs for every year of run-off can be computationally demanding, especially for long-tail lines such as [[Definition:Liability insurance | liability]] or [[Definition:Life insurance | life insurance]]. EIOPA permits simplified approaches — including proportional methods, duration-based approximations, and hierarchies of simplifications — that allow insurers to estimate the risk margin without a full SCR recalculation at each future time step. Under [[Definition:IFRS 17 | IFRS 17]], the cost of capital approach is one of several acceptable methods for determining the [[Definition:Risk adjustment | risk adjustment for non-financial risk]], though the standard does not mandate a specific rate.

💡 Debate around the cost of capital method has intensified in recent years, particularly regarding whether the prescribed rate adequately reflects market conditions and whether the method produces risk margins that are excessively large for long-duration liabilities. A high risk margin increases an insurer's total [[Definition:Technical provisions | technical provisions]], reducing [[Definition:Own funds | own funds]] and potentially constraining the capacity to write new business — a concern raised especially by life insurers and [[Definition:Annuity | annuity]] providers with obligations stretching decades into the future. The 2020 Solvency II review addressed some of these criticisms by introducing adjustments designed to dampen the risk margin's sensitivity to interest rate movements. Beyond regulation, the cost of capital method also informs real-world transactions: when one insurer acquires a [[Definition:Run-off | run-off]] portfolio from another, the risk margin calculated via this method often forms a key component of the transfer price, reflecting the capital cost the acquirer will bear until the liabilities are fully extinguished.

'''Related concepts:'''
{{Div col|colwidth=20em}}
* [[Definition:Risk margin]]
* [[Definition:Best estimate liability]]
* [[Definition:Solvency capital requirement (SCR)]]
* [[Definition:Technical provisions]]
* [[Definition:Risk adjustment]]
* [[Definition:IFRS 17]]
{{Div col end}}

Definition:Cost of capital method - Revision history

PlumBot: Bot: Creating new article from JSON