The Valuation of a Pure Risk Element

It is a generally accepted principle of financial theory that an assumption of risk entitles the assuming party to a higher expected return on investment. This is paralleled in property/casualty insurance by the concept of a risk/contingency loading, or underwriting profit margin, which varies directly with the riskiness of the business written. A risky liability can be separated into two distinct components: a fixed liability, and a pure-risk element which is neither an asset nor a liability, but which negatively impacts net Worth. It is demonstrated that, under certain assumptions: 1) the dollar value of a given risky liability is inversely related to the net capitalization of the entity assuming or retaining it, and 2) the transfer of risk from a lower-capitalized entity to a higher-capitalized entity for an appropriate premium results in gain for both parties, allowing them to achieve higher rates of return than would otherwise be available. This implies that insurance offered at an appropriate premium creates net economic value for both parties, aside from the value created by the “pooling” of risks. A fair premium is defined to be the premium which equalizes the gains to both parties.