Use of the CAPM to Discount Property-Liability Loss Reserves

Discounting loss reserves has become a central issue for property-liability insurers as a result of several developments. The Tax Reform Act of 1986 (TRA) requires property-liability insurers to discount loss reserves at a set rate to determine tax liabilities. Conversely, statutory accounting standards do not allow discounting of loss reserves in most instances. Properly applied, discounting of loss reserves establishes a risk-adjusted present value of loss reserves that reflects the economic value of property liabilities. The discount rate should be expected to vary by line of insurance. The capital asset pricing model (CAPM) is used to determine the appropriate discount rate for loss reserves. The CAPM method is contrasted with current statutory procedures for determining loss reserves and with the discounting methodology legislated by the TRA. Properly discounting loss reserves can solve many of the pricing problems created by statutory accounting distortions. !