Risk margin estimation through the cost of capital approach: some conceptual issues

The Solvency II directive requires that insurance liabilities are valued using a best estimate plus a risk margin. The risk margin should be estimated using the cost of capital approach,that is the cost of the solvency capital requirement—which is computed through a value at risk measure—needed to support the insurance obligation until settlement. The unitary cost of capital applied to the future capital requirement should be fixed. This paper deals with conceptual issues relating to the risk margin estimate through the cost of capital approach. It shows that the Solvency II specification of the methodology is consistent with financial economics. However, the theoretical framework required (a frictionless and normally distributed world) is too far-fetched to be acceptable. Even if these conditions were satisfied, a variable unitary cost of capital must be used.