Chapter 11
This chapter describes a way to estimate the cost of risk using data from the capital markets. We approach the problem from a business perspective as well as an economic perspective. We conclude that both perspectives lead to the same conclusion, that the cost of risk is a property of the exposure being insured, and hence can be valued directly as a percentage of the premium per unit of exposure. Once estimated in this way. The result may be expressed in terms of an imputed allocation of capital and an imputed rate of return on capital, but the cost of capital must be found from the exposure first.
Calculating the risk charge requires a description of the scenarios that lead to unexpected levels of profit or loss as well as a description of the random components of individual claims. The risk charge is a function of the broad capital markets.
The same approach to calculating risk charges can be applied to financia1 under-takings of al1 kinds. When covariance with the market is minimal, the market behaves as if there were a single parameter for the risk charge. When covariance with the market is signifícant, it can be accommodated by adding a second parameter to the description of the capital markets. This approach is consistent with regulation, with business practice, and with general models of economic behavior. The calculations can be put in simple spreadsheets prepared by statistical agencies and individual companies. The regulation of premium rates is simplified dramatically because the cost of capital is simply a charge per unit of exposure or a fraction of expected losses, like loss adjustment expense. The cost of real reinsurance is clearly chargeable in ratemaking because it reduces the cost of capital so much that the indicated premium rate is lower when real reinsurance is present.
