Why Should an Insurance Firm Charge for Frictional Costs?

In this paper, we establish a premium principle that calculates the premium as the sum of present values of claim liability, normal business expense, income tax and frictional cost. The principle provides a "fair" premium in the sense that it generates a fair return on capital. In other words, it automatically produces the correct cost of equity capital without knowing its value. The frictional cost is defined as the sum of all expenses incurred by the firm that exceed the "normal" level or category. We discuss the sources of frictional costs and techniques for quantifying them. If a firm manages its market cap instead of book value, the frictional cost needs to be restated by incorporating its impact on the franchise value.