Cost-of-capital valuation with risky assets

Paper: arXiv 2511.00895

Authors: Hansjörg Albrecher, Filip Lindskog, Hervé Zumbach

Abstract

Cost-of-capital valuation is a well-established approach to the valuation of liabilities and is one of the cornerstones of current regulatory frameworks for the insurance industry. Standard cost-of-capital considerations typically rely on the assumption that the required buffer capital is held in risk-less one-year bonds. The aim of this work is to analyze the effects of allowing investments of the buffer capital in risky assets, e.g.~in a combination of stocks and bonds. In particular, we make precise how the decomposition of the buffer capital into contributions from policyholders and investors varies as the degree of riskiness of the investment increases, and highlight the role of limited liability in the case of heavy-tailed insurance risks. We present a combination of general theoretical results, explicit results for certain stochastic models and numerical results that emphasize the key findings.

Complexity vs Empirical Score

• Math Complexity: 6.5/10
• Empirical Rigor: 3.0/10
• Quadrant: Lab Rats — theoretically deep, empirically untested

Why this score: The paper provides a strong theoretical framework and mathematical formulation for cost-of-capital valuation with risky buffer investments. However, it lacks empirical backtesting on real-world market datasets, relying instead on explicit stochastic models and stylized numerical simulations.

Research Flowchart

  flowchart TD
    A["Research Question: Impact of investing buffer capital in risky assets"] --> B["Inputs: Stochastic models, insurance risks & regulatory frameworks"]
    B --> C["Methodology: Analyze buffer capital split between policyholders & investors"]
    C --> D["Theoretical Analysis & Numerical Simulations"]
    D --> E["Key Findings: Quantified effect of limited liability on heavy-tailed risks"]