Financial Pricing of Insurance in the Multiple-Line Insurance Company
Phillips, Richard D., Cummins, J. David, Allen, Franklin, Journal of Risk and Insurance
Since insurance contracts are financial instruments, it seems natural to apply financial models to insurance pricing. Financial pricing models have been developed based on the capital asset pricing model (Biger and Kahane 1978; Fairley 1979), arbitrage pricing theory (Kraus and Ross 1982), capital budgeting principles (Myers and Cohn 1987) and option pricing theory (Merton 1977; Smith 1979; Doherty and Garven 1986; Cummins 1988; and Shimko 1992). Financial models represent a significant advancement over traditional actuarial models because they recognize that insurance prices should be consistent with an asset pricing model or, minimally, avoid the creation of arbitrage opportunities.
A limitation of the existing financial pricing models is the implicit or explicit assumption that insurers produce only one type of insurance, even though most insurers produce multiple types of coverage (e.g., automobile insurance, general liability insurance, workers' compensation insurance, etc.). The purpose of this paper is to remedy this deficiency in the existing literature by providing a theoretical and empirical analysis of insurance pricing in a multiple line firm. An option pricing approach is adopted to model the insurer's default risk. The standard Black-Scholes model is generalized to incorporate more than one class of liabilities, and pricing formulae are generated for each liability class. The theoretical predictions of the model are tested using data on an extensive sample of publicly traded U.S. property-liability insurers.
Option models of insurance pricing have two primary advantages: First, they explicitly incorporate default risk. This is important given the increase in insurer insolvency rates since the early-1980s (see BarNiv 1990). Second, because of data limitations, the key parameters can be estimated more accurately for option pricing models than for competing models such as the Myers-Cohn (1987) or Kraus-Ross (1982) models.(1)
The standard option pricing model of insurance views the liabilities created by issuing insurance policies as analogous to risky corporate debt. The insurer is assumed to issue an insurance policy in return for a premium payment, analogous to the proceeds of a bond issue. In return, it promises to make a payment to the policyholders at the maturity date of the contract. Using this bond analogy, the value of the insurer's promise to policyholders can be thought of as being like the value of a default risk-free loan in the amount of the promised payment less a put option on the value of the insurer. In reality, however, most insurers issue more than one type of insurance and in this case the analogy with a single debt issue is no longer exact. The problem of pricing multiple classes of debt has been considered by Black and Cox (1976). In their analysis senior debt has priority over junior debt in the event of bankruptcy. However, with multiple lines of insurance, each line has equal priority in the event of bankruptcy (see National Association of Insurance Commissioners 1993), and this is the case investigated in our paper.
In a multiple line insurance company, equity capital is held in a common pool. If one or more lines incur deficits of losses over premiums, the lines in difficulty can draw upon the full amount of the firm's equity capital, including earnings from the "solvent" lines. Given this sharing of resources, it is not obvious how to allocate the cost of equity capital to each line.
There have only been a few prior papers on insurance pricing in a multiple line firm, mostly in the actuarial literature. Nearly all have approached the problem by assuming that the insurer's equity capital is allocated among lines of business, usually in proportion to each line's share of the insurer's liabilities (see Knuer 1987; Derrig 1989; and D'Arcy and Garven 1990). Prices for a given line of insurance then incorporate an aggregate profit charge equal to the assumed cost of capital for the line multiplied by its assigned equity. …