Financial Pricing Models for Property-Casualty Insurance Products: Reserve Valuation Rates

This paper analyzes the relationship between the reserve valuation rate and the indicated premium rate. The reserve valuation rate affects the capital embedded in the reserves. Full value loss reserves contain much embedded capital, whereas fair value reserves contain little embedded capital. The amount of embedded capital in the reported loss reserves affects the return on capital. If the insurer prices its policies to achieve a target return on capital, the amount of embedded capital affects the premium rates. This paper discusses the underlying concepts, and it presents the intuition for the analysis. A companion paper "Federal Income Taxes and the Cost of Holding Capital" extends the analysis to include the effects of federal income taxes and the cost of holding capital. The illustration in this paper is carried over to the companion paper.