An Illustrated Guide to the Use of the Risk Compensated Discounted Cash Flow Method (Proposition 103 Testimony)

A lucid, reader-friendly, and artful presentation, advocacy at its best. Fireman's Fund proposes a Risk-Compensated Discounted Cash Flow method for reviewing proposed rates in accordance with Proposition 103. This Risk-Compensated Discounted Cash Flow method determines a rate for each line of business by discounting the cash flows of the policies under consideration to a present value. The base interest rate used for discounting is a riskless rate; projected policy losses are discounted at a lower. risk-compensated, discount rate. This risk-compensated discount rate allows for profit, to compensate equity holders for the underwriting risk being borne, and is calculated to yield a target rate of return to the equity holders. These calculations produce a benchmark rate used to set premiums. This paper describes the logic used in selecting this method as well as the factors that go into the computation of the risk-compensated discount rate. Also presented is a basic description of the nature of the actual insurance transactions involved and their relationship to the Risk-Compensated Discounted Cash Flow method. Finally, a description of how such a Risk-Compensated Discounted Cash Flow method should be used to calculate a rate is presented.