Cost of Capital Estimation with Application to Workers Compensation Ratemaking

Motivation: This paper discusses how NCCI estimates the cost of capital in its ratemaking framework. The implementation of this actuarial concept in ratemaking is challenging because financial economics offers more than one model for estimating the cost of capital. Even where there is agreement on the model, there may be questions about how to arrive at its input components.

Method: NCCI computes the cost of equity capital using the Discounted Cash Flow (DCF) and the Capital Asset Pricing Model (CAPM) approaches. The DCF method employs forecasts for the rate of dividend growth from Value Line Publishing, Inc. The CAPM model utilizes betas from Value Line Publishing, Inc., and historical returns on T-bills and the stock market from Morningstar, Inc.

Results: The two approaches to estimating the cost of capital are conceptually different and their estimates are similar, yet not identical.

Conclusions: In ratemaking, NCCI relies on two concepts of estimating the cost of equity capital in workers compensation. Important inputs to these approaches rest on long-term averages, thus making these methods robust to short-term economic fluctuations.

Availability: Historical returns on T-bills and the stock market are available from Morningstar, Inc. Dividend growth rates and CAPM betas are available from Value Line Publishing, Inc.

Keywords: Dividend Growth Model, Equity Valuation, Workers Compensation