Beyond the Frontier: Using a DFA Model to Derive the Cost of Capital

Since the middle of the 1990s, Dynamic Financial Analysis (DFA) has become a popular method for insurance companies to compare alternative corporate level strategies (e.g. investment policies, reinsurance structures). Most of the work in this area has focused on determining which strategies maximize reward for a given level of risk. Relatively little attention has been focused on how a company should choose between two strategies that maximize reward for different levels of risk.

This paper will attempt to fill that gap by drawing on current finance theory. In particular, the paper will describe a method that can be used to develop a strategy-specific cost of capital within a DFA model. By comparing the company’s results under different strategies to each strategy’s cost of capital, we will be able to determine which strategy maximizes the value added for the company’s owners. Several practical examples will be shown to demonstrate the usefulness of the approach.

Keywords: Dynamic Financial Analysis (DFA), Cost of Capital, Value Added