Pricing Insurance Policies: The Internal Rate of Return Model

Financial models, which consider the time value of money, surplus commitments, and investment income, are increasingly being used in insurance rate making. This reading shows how an internal rate of return model can be used to price insurance policies. It discusses the framework of the IRR model, the various insurance, investment, and tax cash flows, the surplus commitments and equity flows, and two methods of estimating the opportunity cost of equity capital. It presents an application of the IRR model from a recent Workers’ Compensation rate filing. Finally, it discusses the potential pitfalls in using IRR pricing models.