The Cost of Conditional Risk Financing

This paper develops a risk pricing procedure by examining the role of capital in an insurance transaction. An insurance transaction differs from an investment in that an insurer uses capital at the time a claim is settled rather than when the policy is issued, and only if the damages exceed the premium for the exposure. The premium for the risk transfer, based on treating the use of the insurer’s capital as a loan to the policyholder, is the amount required to ensure that the insurer’s risk and return are in balance, with the expected loan payment representing the risk margin in the premium. The insurer’s cost for providing these loans depends on the returns available on alternate investment opportunities. Risk diversification within a market segment is assumed to benefit the policyholders through reduced prices, while risk diversification across market segments is assumed to primarily benefit the insurer through a reduction in its risk. The specific form on the insurer’s risk pricing function can be determined provided that the insurer operates under a capital preservation criterion in which its losses in one market segment are financed out of the profits earned in other market segments. The paper extends the model to consider expenses, federal income taxes, investment income, supply and demand, the competitive market price, and the time value of money.