Toward A Certain Equivalent Discounted Cash Flow Model

A basic tenet of financial theory is the competitive market's ability to establish efficient and equitable prices for financial securities. The competitive price is a fair price because it generates a rate of return to stockholders that is adequate but not excessive. To understand how competitive markets establish prices, financial theorists have developed models that mimic competitive processes. Such models are relevant to insurance ratemaking because insurance is also a financial security. Although insurance contracts are not traded on organized exchanges, they are priced, in some states, under competitive conditions. In states where prices are regulated, a competitive pricing model would help regulators because of their responsibility to maintain adequate but not excessive prices. Rate models based on sound financial theory would also promote the public understanding of ratemaking procedures and establish a higher common ground for debate. Rather than debating the propriety of the ratemaking procedure, participants could focus on the best measures of model variables. Profit Factor, Rate of Return, Risk