Discounting
Financial technique that converts future cash flows to their equivalent present value, by dividing by a compounding factor.
United Kingdom, 2017: the discount rate for personal injury damages (the Ogden rate) goes from 2.5% to −0.75% on March 20, then to −0.25% in 2019 and to +0.5% in January 2024. Each move shifts the cost of the periodical payments liability insurers must reserve for. Discounting is the inverse of compounding: it calculates the present value (PV) of a future cash flow F expected in n periods, at discount rate r. Formula: PV = F / (1 + r)^n. The principle: 1 EUR in the future is worth less than 1 EUR today (time preference, inflation risk, opportunity cost). In actuarial work, claims reserves can be discounted to reflect the time value of money (Solvency II requires it). In life insurance, unit-linked liabilities and annuities are discounted at the technical rate. The discount rate sets the size of the reserves: a higher rate reduces them, but increases risk if future rates turn out lower.
Textbook case: expected claim payment in 5 years: 1,000,000 EUR. Discount rate 3%: PV = 1,000,000 / 1.03^5 ≈ 862,609 EUR. The discounted reserve is 137K EUR below the undiscounted reserve.
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