Financial Pricing of Property and Liability Insurance

Abstract

Insurance companies are levered corporations that borrow money by issuing a specific type of debt instrument, the insurance policy. Insurance debt is more risky than conventional debt because neither the amount nor the timing of the debt repayments are known in advance. The debt analogy suggests financial modeling as a natural approach to the pricing of insurance. This paper reviews the theory of financial pricing of insurance and proposes some extensions. The review covers the insurance capital asset pricing model CAPM, discounted cash-flow models, and option pricing models. The extensions include an option model of the insurance firm allowing for multiple asset and liability classes and an analysis of insurance company equity as a down-and-out option.