How should an actuary determine premium rates for insurance policies? Early rating bureau pricing procedures incorporated a fixed underwriting profit margin, such as 2.5% for Workers’ Compensation and 5% for other lines of business. The simplicity of this approach led to its continued use by the actuarial profession.
During the past two decades, economists, financial analysts, and casualty actuaries have proposed alternative pricing models, sparked by the lack of theoretical justification for the traditional procedure, the high interest rates in the American economy, and the increasing competitiveness of the insurance industry. More precisely, the stimuli for more accurate pricing models fall into three categories:
( 1 ) Tfie time value of money: Insurance cash flows on a given contract occur at different times. Of&en, premiums are collected and expenses are paid at policy inception, whereas losses are settled months or years later. Monies exchanged at different dates have different values, which we relate to economic inflation, available interest rates, or the opportunity cost of capital. Financial insurance pricing models consider both the magnitudes and the dates OF cash transactions.
( 2 ) Competition and expected returns: In a free market economy, the price of a product depends on the degree of competition in the industry. If a firm prices its product above the market level, it may lose sales. If it prices its product below the market level, its profits may fall. The optimal price for products whose costs are known in advance of the sale is determined by production costs and competitive constraints. Complex insurance products, however, require an a priori analysis of both expected costs and achievable returns.
( 3 ) The rate base: The underwriting profit margin is a return on sales. Businessmen in many industries measure profits in relation to sales, though this method is not favored by financial analysts and theoretical economists. Alternative rate bases are assets, which are used in public utility rate regulation, and equity (or net worth), which is used in most financial pricing models.
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Pricing Insurance Policies: The Internal Rate of Return Model
