Determining the Proper Interest Rate for Loss Reserve Discounting: An Exonomic Approach

Property-liability loss reserves have been historically maintained at full, undiscounted value while life insurance reserves are discounted. Proponents of the undiscounted value argue that, unlike P/L loss reserves, life insurance benefits are relatively certain and thus more amenable to discounting, since the liability is more likely to be realized. Others argue that the time value of money cannot be ignored, and all future liabilities should be properly discounted to reflect economic net worth. This paper demonstrates that the views of both sides have merit, and are incorporated into the proper economic result. The paper assumes that discounting of P/L reserves is appropriate and focuses on the selection of the correct interest rate used in the discounting procedure. By applying underlying economic principles to insurance, the proper interest rate for loss reserve discounting is shown to be a function of the degree of risk present in the outstanding reserve. When loss reserves are certain, the discounting interest rate equals the market interest rate for a riskless security having cash flows matching that of the loss reserve. When the loss payments are uncertain, a risk adjustment to the riskless discounting rate is derived. An analysis of empirical property-liability data over a 15-year period is performed, using a pricing model incorporating the risk-adjusted interest rate. Results show that the risk adjustment for aggregate industry loss and loss expense reserves is positive for this period, but may vary by line of business.