Buying organizations can put their excess cash to work to gain early payment discounts that decrease COGS, improve margins, and earn a high yield return on liquidity. Suppliers benefit from the flexibility of discounting some or all of their receivables.
For suppliers, dynamic discounting provides the flexibility to be paid earlier than the invoice maturity, often at more attractive terms than alternative methods such as asset-based lending or factoring.
Many important decisions concerning our health, wellness, finances, and careers are affected by hyperbolic discounting. All of these choices require trading off immediate pleasure for your future good.
Acknowledging the effect of hyperbolic discounting on our daily decision making and consciously evaluating trade-offs between the present and future, can help you do what you really want. Trust me, future you will be thankful.
John decided to take the first option, even though he would receive less money from it in the long-run. His preference towards immediate benefits over future gain can be attributed to hyperbolic discounting.
Another way to look at this, is that hyperbolic discounting can also make us blind to the benefits of long-term decision-making, which can sometimes include gains far greater than those of more immediate decisions. For example, if one had money to spare, it may be wise to invest some of it for retirement. But overvaluing the short term gratification one would get from buying food or clothes may lead them not to invest. This may have been a poor decision, as they would probably have benefited much more from having this money compound interest for their future retirement.
As mentioned before, the impulsivity and search for immediate gratification that hyperbolic discounting encourages can be damaging in many aspects of our lives. It can also make us miss out on better opportunities that come to fruition in the long-term, as they often do.
Another clear reason why we should be aware of hyperbolic discounting, is that studies link it to procrastination. When we put-off or avoid a task, we are essentially prioritizing the immediate gratification of not undergoing an unpleasant experience over the future reward from completing the task. Most of us suffer from procrastination to some degree, and would benefit from mitigating it.7
Yet, these products and sources of energy serve an immediate need at a low initial cost. Many of us are willing to continue using them and absorbing their externalities because we discount the future costs they will have. This may be due to hyperbolic discounting.
Another reason hyperbolic discounting occurs is that waiting is difficult because of our non-linear perception of time. This means that time seems to go by slower or faster depending on our situation and our expectations for the future.
Environmental degradation is a clear example of short-term thinking. The enormous long-term costs of carbon intensive activities and technologies are now clear, but they do serve an immediate need at a low initial cost. Many of us are willing to continue using them and absorbing their externalities because we discount the future costs they will have. This may be due to hyperbolic discounting.
In a 1989 paper, high school dropout rates are used to illustrate discounting. A change in West Virginia law stipulated that students under the age of 18 who choose to prematurely leave school also lose their driving licenses. A year after the law was implemented, high school dropout rates fell by one third. It is unlikely that this many students were on the edge of dropping out and losing their drivers license tipped their rational calculus was tipped in favour of staying enrolled. It is more likely that being unable to drive legally simply had an effective deterrent effect. This means that students prioritized this relatively short-term reward in their decision to leave or remain in school.
This standard addresses the discounting to present value of unpaid claim estimates for property/casualty coverages. In determining the undiscounted unpaid claim estimate, the actuary should be guided by ASOP No. 43, Property/Casualty Unpaid Claim Estimates.
The actuary should be aware of the context in which the discounted unpaid claim estimate is to be used. The actuary should use a methodology and assumptions in the discounting process that are appropriate for that context.
In 1992, the ASB issued ASOP No. 20, Discounting of Property and Casualty Loss and Loss Adjustment Expense Reserves. Prior to that, there was no standard of practice concerning discounting of property and casualty loss and loss adjustment expense reserves. Since the issuance of ASOP No. 20, the ASB has issued ASOP No. 36, Statements of Actuarial Opinion Regarding Property/Casualty Loss and Loss Adjustment Expense Reserves, and ASOP No. 43, Property/Casualty Unpaid Claim Estimates. This revision provides more consistency with the language in these two ASOPs and is more relevant now with the increased use of discounting related to fair value calculations.
The appropriateness of discounting unpaid claim estimates in various financial reporting contexts is a controversial topic. Traditionally, property and casualty unpaid claim estimates have not been discounted except in certain narrowly defined circumstances. However, the issue of discounting reserves has been discussed for many years. For example, the issue appeared in the 1927 Proceedings of the Casualty Actuarial Society, in an article by Benedict D. Flynn. In 1986, the U.S. Congress passed legislation prescribing discounting procedures for income-tax purposes. In the past, most state insurance departments prohibited discounting; some departments have permitted discounting for some lines of business. The National Association of Insurance Commissioners has consistently been opposed to discounting except in certain specific circumstances. The accounting profession is studying the issue as it relates to financial reporting.
Historically, the issue of reserve discounting has been closely related to the issue of risk margins. Undiscounted reserves are often considered to contain a needed implicit risk margin in the difference between undiscounted reserves and discounted reserves. If discounted reserves were incorporated into financial statements, many would argue that an explicit risk margin would become necessary. Suggestions for the treatment of that risk margin include treatment as a liability item, a segregated surplus item, or an off-balance-sheet item.
The discounting of unpaid claim estimates and risk margins are both important elements in estimating the fair value of unpaid claim estimates, yet neither is explicitly included in most current financial reporting. Much of the rationale for unpaid claim estimate discounting is related to the issue of fair value; however, some believe that discounted unpaid claim estimates without risk margin may be a poorer estimate of fair value than undiscounted unpaid claim estimates.
Unpaid claim estimate discounting calculations are commonly performed in conjunction with valuations of insurance companies for purposes such as acquisition or merger, or with transfers of portfolios or unpaid claims. In these instances and for other reasons, there are increasing numbers of circumstances where actuaries are asked to determine or evaluate discounted unpaid claim estimates.
Actuaries are currently guided by the existing ASOP No. 20. Other ASOPs issued by the Actuarial Standards Board pertaining to discounting of unpaid loss and loss adjustment expense estimates include ASOP No. 23, Data Quality; ASOP No. 36; ASOP No. 41, Actuarial Communications; and ASOP No. 43. In addition, disclosures related to discounting are required by the National Association of Insurance Commissioners, and guidance may be forthcoming as part of new International Financial Reporting Standards that are currently under development.
Numerous educational papers are in the public domain that are relevant to the topic of discounting and risk loads, including those published by the Casualty Actuarial Society. While these may provide useful educational guidance to practicing actuaries, these are not actuarial standards and are not binding.
Some economists argue that using any positive discount rate is inappropriate. In essence, this argument holds that discounting more heavily weights the welfare of those alive today relative to that of those who are yet to be born and is, therefore, immoral. However, this view is based on a flawed understanding of discounting. The discount rate reflects the value of alternatives to the policy in question. It is not a tool for diminishing relative importance of life or utility in the future.
Not all questions of discounting, however, are so obvious. When the costs and benefits of an investment or a policy occur at different times they need to be compared in a way that accounts for these time differences. The guiding question for the comparison is straightforward: How much would have to be invested today to generate the future value in question?
Table 1 illustrates how the future is shortchanged if discounting is done with 3 percent when 7 percent returns would be available. The chart shows how a 3 percent discount rate equilibrates the present and future values when the cost of cutting CO2 is $104.07 per ton. With a 3 percent rate of return, $104.07 in 2016 would grow to $2,000 in 2116. However, if the current generation undertook projects with a 7 percent return rate, the return would grow to a value of more than $90,300.
Discounting is the inverse of compounding. For any amount in the future the present value (or discounted value) is the amount that, if invested today, would compound out to that future value. In the example above, the present value of $121 to be received two years from now discounted at 10 percent per year is $100. The general formula for compounding can be rearranged to give the general formula for discounting as: