Risk Loads for Insurers

This paper provides a critique of risk loading methods then in use and proposes that CAPM may provide an alternative. Abstract: Insurance companies are risk averse, even as individuals are. Casualty actuaries have suggested several methods of calculating risk load to compensate the insurer for the risk it accepts. Methods current in sue, and reviewed in this paper, consider (a) the standard deviation and variance of the loss distribution, (b) utility functions, (c) the probability of ruin, and (d) reinsurance costs. These methods are theoretically unsound. They consider the wrong type of risk; they arbitrarily equate risk with a mathematically more tractable variable; and, they require equally arbitrary assumptions about an insurer's aversion to risk. More importantly, they concentrate on the size of loss distribution, though the true risk to the insurance company resides in profit fluctuations. Modern portfolio theory measures the risk assumed by investors in securities. Systematic risk, the overall risk faced by a diversified stock portfolio, requires an additional premium. Firm-specific risk, or the fluctuations in an individual stock's price, can be eliminated by diversification and is not compensated for in security returns. Insurance equivalents to modern portfolio theory can be applied to insurance portfolios to determine risk premiums by line to be highly risky and the Personal Property lines to be less risky. In sum, this method allows insurers to measure the true risk they face in each line of business. Keywords: Profit Factor, Rate of Return, Risk