Measuring the Cost of Capital in the Property and Casualty Insurance Industry

Posted Date: Winter 2008, Revised: December 2010
    

The Discounted Cash Flow (DCF) and Capital Asset Pricing Model (CAPM) approaches are widely used for estimating the cost of equity capital in regulated (and unregulated) industries.  NCCI employs both concepts in estimating the cost of equity capital for the Property and Casualty (P&C) insurance industry as part of its ratemaking process.

Periodically, NCCI reviews its cost of capital methodology in the light of new research findings.  The latest revision of the cost of capital, which dates December 2010 and replaces the methodology established in January 2008, resulted in the following notable changes:

  • The growth rate of dividends in the second stage of the Gordon growth model is now approximated by the long-term growth rate of GDP.  Previously, NCCI made use of the postwar growth rate of total financial assets of the P&C industry.
  • Now, the industry beta is obtained as a full-information market-capitalization weighted beta, whereas previously, the beta was a simple average (arithmetic mean).
  • Now, NCCI calculates the risk-free rate as a weighted average of the current risk-free rate and the historical return on short-term Treasury securities over the period 1926-2010.  The current yield of Treasury bills with a maturity of 30 days was given a weight of 0.33, and the average historical return on T-bills was given a weight of 0.67.  The prior methodology made use of the historical average only.
  • NCCI no longer adjusts the historical average stock return for a secular decline in the dividend yield; this is because this secular decline has reversed during the past couple of years.
  • Due to increases of share repurchases during the past couple of years, NCCI now assumes that the effective dividend yield (report dividend, adjusted for share repurchases) is twice the reported dividend yield.  Previously, the reported dividend yield (after adjusting for its secular) was adjusted for share repurchases by adding 50 basis points.
  • Taken together, these methodological changes increased the NCCI estimate of the cost of capital of the P&C industry from 10.39 percent to 11.28 percent at the time the paper was written (December 2010).