Legal Definitions - fair rate of return

A fair rate of return refers to the reasonable profit or income that an investor or company is permitted or expected to earn on their investment. This rate is considered adequate to compensate for the capital invested and the risks taken, without being excessive or exploitative. It often involves a balancing act, particularly in regulated industries, to ensure that consumers receive affordable services while investors are incentivized to provide necessary capital and maintain quality.

Here are some examples illustrating the concept of a fair rate of return:

• Regulated Utility Company: Imagine a state public utility commission reviewing a local electricity provider's request to increase its rates for residential customers. The electricity company argues that it needs higher rates to cover the costs of upgrading its power grid and to attract investors for future infrastructure projects.

  The commission's role is to determine a fair rate of return. This means setting rates that allow the electricity company to cover its operational expenses, maintain reliable service, and earn a profit that is reasonable for its shareholders, encouraging continued investment. At the same time, the rates must not be so high that they unduly burden consumers, ensuring a balance between investor interests and public affordability.

• Government Contract for Public Infrastructure: Consider a private construction firm that enters into a long-term agreement with a city to build and operate a new public transportation system, such as a light rail line. The firm invests a significant amount of its own capital into the project, expecting to recoup its investment and make a profit over several decades through fares and government subsidies.

  The contract terms, including the fare structure and subsidy levels, would be designed to ensure the private firm achieves a fair rate of return on its substantial investment. This incentivizes the company to undertake the project, manage it efficiently, and maintain the system, knowing it will be adequately compensated for its capital and the risks involved, while the public benefits from improved transportation.

• Insurance Premium Regulation: A state's department of insurance is tasked with approving the premium rates that auto insurance companies charge their policyholders. An insurance company submits a proposal for new rates, arguing they are necessary due to rising claims costs and administrative expenses.

  The regulators must evaluate these proposed rates to ensure they allow the insurance company to maintain financial solvency, pay out claims, cover its operating costs, and earn a fair rate of return for its investors. If the approved return is too low, the company might struggle to attract capital or even exit the market, reducing consumer choice. If it's too high, consumers would be overcharged for their insurance coverage, demonstrating the need for a balanced and fair approach to profitability.