The Impact of Alternative Specifications of the Equity Risk Premium on NCCI’s Cost of Capital and Internal Rate of Return Models

Posted Date: March 2005

The equity risk premium is typically defined as the additional return—above the return obtainable on a risk-free security, such as a US government bond—that investors require as compensation for assuming the nondiversifiable risks associated with investing in common stocks.

Key Findings

  • A growing body of research suggests a “range of reasonableness” for the prospective equity risk premium of 1% to, at most, 3%—substantially less than the historical average risk premium of roughly 7%.
  • Changes in the equity risk premium have similar directional impacts on NCCI’s financial models. For example, a lower risk premium reduces both the expected return on common stocks and, to a lesser extent, the estimated cost of capital. As a result, the factor needed to adjust the ultimate insurance rate to generate the P/C industry’s cost of capital (i.e., the underwriting contingency factor or UCF) has a muted sensitivity to changes in assumed values of the equity risk premium.
  • As a corollary, when analysts are developing estimates of the appropriate UCF, the specific estimate of the equity risk premium is less critical than making sure that the processes used to estimate the cost of capital and the investment return on common stock are consistent.
  • Although creating pharmacy benefit managers (PBMs) initially looks promising as a cost containment strategy, additional factors will need to be assessed and addressed.