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

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.1 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 implementation of the DCF and CAPM approaches in the light of new research findings.2 The latest such review was completed in May 2007 and resulted in a number of significant changes to NCCI’s methodology. Those changes are summarized in this article (with additional detail provided in the Technical Appendix). The key methodological changes include the following: • NCCI’s DCF model now calculates the prospective dividend growth rate (a key input to the DCF approach) via a two-stage approach wherein a near-term forecast of dividend growth is followed by an infinite period of average dividend growth based on the expected growth in total financial assets in the P&C industry. NCCI’s prior methodology used an average of dividend growth rates using historical and forecast data. The changes result in a downward revision in the DCF measure of the cost of capital to 10.62% from 11.74% previously (based on data available as of May 2007). • The CAPM model now rests on an equity risk premium that reflects the difference between the total return on the S&P 500 stock price index over the 1926–2006 period (adjusted to hold the implied dividend yield constant at its 1926 level) and the long-term average rate on US Treasury bills. The resulting equity risk premium is now estimated to be 7.59%, instead of the previously selected estimate of 3%). The change in methodology raises the CAPM cost of capital to 11.02%, up from 7.75% using the previous methodology. • Taken together, these methodological changes increase NCCI’s estimate of the P&C industry’s cost of capital to 10.82% from 9.75% previously, based on an averaging of the DCF and CAPM measures.