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Question:
A proprietary life company issues only non-profit guaranteed growth bonds. The company invests only in equities with an expected return of 10% p.a, the risk free rate being 5% p.a. At the balance sheet date there were £100m of equities and growth bonds with a maturity value of £80m, the bonds all maturing in exactly one year's time.
(i) Assuming that the possibility of default by the insurance company may be ignored, calculate, using the result of Modigliani Miller for the cost of equity capital or otherwise, the appropriate risk discount rate to value the shareholder s interest in the portfolio of growth bonds
(ii) Explain the theoretical impact on the risk discount rate of allowing for the default of part or all of policyholder benefits.
(iii) (a) Describe what is meant by franchise value in the context of a life company.
(b) Explain in general terms how the franchise value varies with the amount of capital on the life company balance sheet.
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