On the Determination of Appropriate Profit Margins in Insurance Industry Regulation

Abstract

It is shown that using the CAPM to determine profit margins for property-liability insurance companies presents regulatory commissions with a set of implementation difficulties. These difficulties arise from the unacceptably wide range of acceptable profit margins generated using the CAPM. In particular, if beta is calculated using the appropriate data differencing interval, the confidence intervals may be so wide as to produce unreliable estimates of both beta and profit margin. Use of the Capital Asset Pricing Model (CAPM) has become widespread by regulatory commissions in the rate setting process. Since the Hope decision,' the legal standard for determining rates of return has been that the returns be 'commensurate with returns on investments in other enterprises having corresponding risks.' It is claimed that the CAPM enables regulators to determine consistent risk adjusted rates of return and commensurate profit margins. Venezian, however, has recently suggested that the CAPM is unsuitable on theoretical grounds for use in insurance industry regulatory proceedings. He cites circularity in the arguments made by those using the CAPM since an exogenous rate increase is based upon the results of the CAPM which in turn are based upon the rate increase. Venezian has also recently suggested [1 14 that financial theoretic approaches such as the CAPM lose relevance in the regulation of businesses which are structured competitively and for whose assets there are viable financial markets.' While other difficulties have been addressed in using the CAPM in a regulatory framework [ 1,2,3,7,8,9,10], it is still one of the central models upon which allowed rates of return and profit margin are based. Fairley [4] recently proposed an approach to determine equilibrium rates of return and appropriate profit margins for property-liability insurers using the CAPM. His approach calculates the insurer's profit margin as a function of its calculated systematic risk, beta. The purpose of this paper is to show, using Fairley's profit margin model, that in situations where the CAPM is utilized to determine profit margins, the Allen Michel is Associate Professor of Finance at Boston University. James Norris is a Corporate Banking Officer at Bay Bank Harvard Trust Company. The research was completed while the author was associated with the Corporate Research and Planning Group at Liberty Mutual Insurance Company. ' Federal Power Commission v. Hope Natural Gas Co., 320 U.S. 591, 603 (1944). 2Personal communication with Venezian.