This paper aims to suggest an estimation method of discount rates for insurance liability valuation reflecting the term structure of liquidity premium under IFRS 4 Phase II. The advantage of our method is that it is not only theoretically solid, but also practically applicable.
The main findings are as follows: First, the extended Fama-French model, including government-guaranteed bond spread as a liquidity factor, is suitable to determine corporate bond yield spreads. Second, the liquidity risk factor is priced within the cross section of each bond rating and maturity. Third, the Smith-Wilson model exhibits substantially better fitted extrapolations for the term structure of risk free rates, compared to the Nelson-Siegel model and the Svensson model. Fourth, the term structure of liquidity premiums for corporate bonds of each rating as well as government bonds is estimated to reflect the characteristics of cash flows of insurance liabilities. Finally, liquidity risk premiums of Korean government-guaranteed bonds and corporate bonds with AAA, AA, and A ratings are estimated to be 10, 18, 38, 70 bps, respectively on three-year maturity basis at the end of 2015.