Setting the risk discount rate in valuing liabilities

Question

What's the justification for using a higher discount rate to value risky liabilities? Surely this gives them a low present value, which would suggest we should hold less capital to cover the liability?

Answer 1

The idea of using the interest rate to allow for risk in valuation of cashflows needs to be measured up against this problem. For many valuations, for example in Captial Project appraisal, the cashflows later in the project are positive (income) so if they are uncertain then a high i will devalue them appropriately.

In valuation of liabilities, it is more cautious to use a low i rather than a high i.

So the choice of i for prudence needs to be made in the context of the thing that you are doing. There are other ways to allow for risk (using i is a crude way) - for example cashflows can be assigned probabilities or increased to allow for risk.