On the Use of Option Pricing Models for Insurance Rate Regulation

Abstract

In the past decade, insurance regulatory authorities have witnessed the introduction of various economic or quasi-economic models for estimating the “fair” rate of return on equity. These models succeeded earlier rules of thumb such as the target of 5 percent underwriting profit. The economic model that has received most attention is the Capital Asset Pricing Model (CAPM). However, this model has serious flaws arising from its stylized treatment of taxes, its failure to consider the possibility of ruin, and the difficulties associated with measuring underwriting betas. More recently, models based upon option pricing theory have been applied to insurance pricing in an attempt to address at least some of the flaws of the CAPM. In this chapter, we discuss the use of option-based models for insurance pricing and will summarize two recent applications by the authors. We will then present specimen applications of these models using workers’ compensation data. For comparison, we show comparable results for the CAPM.