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The Financial Theory of Pricing Property-Liability Insurance Contracts.

The Financial Theory of Pricing Property-Liability Insurance Contracts

Incorporating economic and financial theory into the property-liability ratemaking process is the primary objective of this monograph. Since the implications of these models often run counter to the prevailing logic within the actuarial community, it was the authors' intent to present the competing financial models, explain their rationales, and discuss their relative merits as practical alternatives to current pricing strategies. The target audience of actuaries, regulators, and insurance academics will find the text mathematical but comprehensible. Economic explanations and implementational issues are emphasized.

To set the economic stage, the profit-maximizing strategy for a publicly-held insurance firm is developed. From this straightforward application of macroeconomic models, the mystery of "cash flow" underwriting is readily explained. Equity-holders in the firm receive compensation as either investment income or underwriting profits, but the source of their earnings does not concern them. When investment opportunities are particularly attractive, the prospect of underwriting losses produced by "inadequate" rates is counterbalanced by the higher investment income. Managers acting rationally (in the economic sense) will pursue underwriting strategies that seem suicidal but are in fact profitable.

From this very basic result, the crucial difference between existing insurance pricing strategies and those derived from the financial models is evident: the price of insurance cannot be set in a vacuum, but must be tied to the investment return required by shareholders in the firm. Insurance prices are established at levels consistent with the risk-return characteristics prevailing in the financial markets, i.e., rates are set to assure sufficient capital flow to insurance firms by adequately compensating the providers of that capital. The process by which mutual insurance companies establish their rates is not specified, but is presumably handled by competitive forces.

The question of appropriate risk measures is addressed by presenting two standard financial market models relating risk and return: the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Model (APM). D'Arcy and Doherty provide an excellent discussion of the CAPM's logic. Its brevity and clarity should serve as a model to authors of introductory finance textbooks. Within the CAPM framework, only systematic or market-related risk is compensable, a feature which has created much debate regarding its applicability to insurance firms. Other features of the model (e.g., restrictive assumptions) and implementational problems (e.g., estimation of risk as measured by the underwriting beta) are also unsettling to insurance practitioners. Modifications are presented to deal with the former issue, making the model more realistic for the insurance case. The extent to which recent research has addressed the latter issue suggests that progress will continue in the practical area.

Nonetheless, dissatisfaction with the CAPM has led researchers to explore the Arbitrage Pricing Model (APM) as an alternative risk-return model. APM is capable of incorporating several sources of risk into its determination of the required rate of return on equity, from which insurance prices are derived. Such generality is not without its own problems, however, notably model specification and estimation. The theoretical and practical limitations of APM suggest that it will not soon replace CAPM.

An area of more current interest, option pricing, is explored as an alternative to the market-related models. Risk within these models is measured by the variability of losses, a comforting retreat to traditional thinking. The required distributional assumptions of normality or lognormality limit the applications of the model, however. Unfortunately, the authors did not provide this model with as lucid an explanation as one had come to expect from them, due to the complexity of the derivation. Since the target audience is presumed to have limited background in financial theory, insightful discussion is imperative. The conclusions drawn must be accepted without understanding their logic, a highly unsatisfactory approach. Perhaps practical illustrations might have been incorporated into the discussion to enhance comprehension. The appendix, full of data and results of simulation experiments, failed to explain its significant results, and so seemed superfluous.

Discounted cash flow (DCF) techniques are also presented within the context of insurance pricing decisions. Emphasis is placed on those characteristics of insurance which make the application of DCF more judgmental than scientific. DCF techniques' reliance on a properly specified required rate of return to capitalize the cash flows highlights the importance of resolving the issue of the appropriate risk measure.

On the whole, the monograph does a remarkable job in presenting difficult conceptual material at a level consistent with the education and intelligence of its target audience. Actuaries, regulators and students of insurance will become familiar, if not proficient, with standard financial concepts and techniques. Unresolved disputes are acknowledged, their competing arguments outlined, but where no consensus has been reached the authors do not force conclusions. The debate will be stimulated and advanced by the contributions of this audience.
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Author:Wiltbank, Laurel J.
Publication:Journal of Risk and Insurance
Article Type:Book Review
Date:Jun 1, 1989
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