Cost of capital
The return shareholders require on the capital tied up to absorb unexpected losses, which on that account enters the price of every risk.
The cost of capital is the return equity providers require in exchange for the risk they bear. For an insurer, the capital held beyond technical provisions serves to absorb unexpected losses, and it has a cost even when invested: what it earns in bonds is less than what shareholders expect, and the gap, plus tax and agency frictions, must be paid for by premiums. That is why a risk that ties up a lot of capital, such as a high catastrophe layer, sells at a high multiple of its expected loss. Solvency II makes it a regulatory parameter: the risk margin is computed with a 6 percent cost-of-capital rate, which the review adopted at the end of 2024 through Directive (EU) 2025/2 brings down to 4.75 percent. In pricing, the cost of capital multiplied by the capital allocated to the risk forms one line of the technical price.
Textbook case: a portfolio whose projected regulatory capital is 100 million euros in the first year, 60 in the second and 20 in the third carries, at the 6 percent rate, a risk margin of about 10.8 million before discounting. At the revised 4.75 percent rate, it falls to 8.55 million: a single regulatory parameter moves more than two million.
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