cost of capital and risk margin
Suppose you are about to take over someone else's insurance promises — you will receive a pot of money and, in exchange, must pay all the future claims. How much should that pot be? Clearly enough to cover the expected claims. But would you really take the deal for just the expected amount? No — because the claims are uncertain, and someone has to lock up real capital for years to make sure they get paid even if things go badly. You would demand a little extra to compensate for tying up that capital. That little extra is the risk margin, and the cost of capital is the rate at which it is calculated.
Concretely, under Solvency II and similar regimes the value of an insurer's obligations (the technical provisions) has two parts: the best-estimate liability (the present value of expected future claims and expenses, a fair average) plus a risk margin on top. The risk margin is computed by the cost-of-capital method: project the regulatory capital (the SCR) that a reference insurer would have to hold for these obligations in every future year until they run off, multiply each year's capital by a prescribed cost-of-capital rate (historically 6% per year under Solvency II) to get the annual 'rent' on that capital, and discount all those rents back to today. The sum is the risk margin — the amount a buyer would need on top of the best estimate to be fairly paid for carrying the run-off risk.
This matters because it makes the balance sheet honest: liabilities are valued not at their bare average but at what it would actually cost to transfer them to a willing third party, which is the market-consistent ideal. It is the reason two insurers with identical expected claims can hold different liability values if one's business is riskier and capital-hungry. The common misconception is that the risk margin is a hidden profit cushion or a slush fund; it is neither — it is the explicit price of the capital that must stand behind uncertain promises, and the cost-of-capital rate is a policy lever (debated and occasionally lowered) that directly moves how big that price is.
An insurer's annuity book has a best-estimate liability of 1,000. To hold the SCR backing it over the decades until the last annuity is paid would, year by year, 'rent' capital at 6% a year; discounted to today those rents sum to 40. The technical provision is therefore 1,040 — the 40 risk margin is the price of the capital standing behind the promise.
Technical provision = best estimate + risk margin (the rent on required capital).
The risk margin is not hidden profit or a slush fund; it is the explicit cost of holding capital behind uncertain promises, and the cost-of-capital rate is a debated policy choice.