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Risk Adjusted Discount Rate

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THE DIRECT D E T E R M I N A T I O N of RISK-ADJUSTED DISCOUNT RATES and LIABILITY BETA

RUSSELL E. BINGHAM T H E H A R T F O R D FINANCIAL SERVICES G R O U P

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Subject Abstract 1. Summary 2. Total Return Model 3. After-Tax Discounting 4. Derivation of Risk-Adjusted Discount Rate and Liability Beta Figure l : Baseline Risk / Return Line vs Leverage 5. Liability Beta Figure 2: Equity vs Liability Beta Figure 3: Equity Beta vs Risk-Adjusted Discount Rate (After-Tax) 6. Underwriting Profit Margin Figure 4: Underwriting Profit Margin vs Loss Payout Figure 5: Underwriting Profit Margin vs Investment Yield Figure 6: Underwriting Profit Margin vs Market Risk Premium Figure …show more content…

Secondly, the importance of using after-tax discount rates and the

equivalency of net present value rates of return and internal rates of return that follow as a consequence is reviewed, again discussed in detail in [1], [2] and [3]. This foundation provides the critical model structure and valuation framework from which risk-adjusted discount rates and liability beta can be determined.

An important principle is introduced - that being that the risk-adjusted total rate of return must equal the risk-free rate. This fundamental principle provides a stepping stone from which a direct estimate of the liability beta becomes possible within the total return framework. Liability betas are shown in The

relationship to the total return to shareholders and the linkage with equity betas demonstrated.

sensitivity of the underwriting profit margin to variations in loss payout, investment yield, market risk premium and leverage is demonstrated and discussed.

Liability betas cannot be directly measured, and Cummins [6] and Fairley [9] presented approaches to estimate them. Kozik [10] discussed the many problematic aspects of CAPM and liability beta theory, demonstrating why any estimate of liability beta is likely to be subject to much debate. It is important to keep in mind, however, that the development of a liability beta is a secondary objective to that of determining the appropriate risk-adjusted discount, rate. This paper proposes a shift in focus

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