Estimating Divisional Cost of Capital for Insurance Companies

  • Franklin Allen
Part of the Huebner International Series on Risk, Insurance, and Economic Security book series (HSRI, volume 17)


In a competitive market, what should the rate of return on insurance companies’ equity be? What premiums should insurance companies charge? Traditionally, the answers to these questions have been based on actuarial and accounting concepts.1 More recently financial models of the insurance firm have been developed. Ferrari (1968) suggested a descriptive model which allowed an algebraic expression for the rate of return on equity as a function of the premiums charged to be derived. Combining this with the capital asset pricing model (CAPM) meant that an equilibrium value for the return on equity and the corresponding level of premiums could be found. This model is known as the insurance CAPM.2 The development of other asset pricing models in finance has also led to insurance counterparts. Thus the Arbitrage Pricing Theory, and option pricing models have been used to derive the return on equity and the level of premiums.3 Although the approaches based on asset pricing models have advantages compared to those based on traditional actuarial and accounting concepts, they are not ideal. One of the most important problems is that they are not well suited for finding premiums when an insurance company has multiple divisions. The difficulty is that it is not clear how earnings on reserves should be allocated among the various divisions of the firm.


Capital Market Optimal Portfolio Risky Asset Financial Management Insurance Contract 
These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.


Unable to display preview. Download preview PDF.

Unable to display preview. Download preview PDF.


  1. Allen, F. and D. Gale (1991). “Limited Market Participation and Volatility of Asset Prices,” Rodney L. White Center Working Paper 2–92, University of Pennsylvania.Google Scholar
  2. Biger, N. and Y. Kahane (1978). “Risk Considerations in Insurance Ratemaking,” Journal of Risk and Insurance 45, 121–132.CrossRefGoogle Scholar
  3. Blume, M., J. Crockett and I. Friend (1974). “Stock Ownership in the United States: Characteristics and Trends,” Survey of Current Business, 16–40.Google Scholar
  4. Blume, M. and I. Friend (1978). The Changing Role of the Individual Investor: A Twentieth Century Fund Report, New York: Wiley.Google Scholar
  5. Cooper, R. W. (1974). Investment Return and Property-Liability Insurance Ratemaking (Philadelphia: S.S. Huebner Foundation, University of Pennsylvania).Google Scholar
  6. Cummins, J. D. (1990a). “Asset Pricing Models and Insurance Ratemaking,” Astin Bulletin 20, 125–166.CrossRefGoogle Scholar
  7. Cummins, J. D. (1990b). “Financial Pricing of Property and Liability Insurance,” Working Paper, University of Pennsylvania.Google Scholar
  8. Cummins, J. D. (1990c). “Multi-Period Discounted Cash Flow Ratemaking Models in Property-Liability Insurance,” Journal of Risk and Insurance 57, 79–109.CrossRefGoogle Scholar
  9. Cummins, J. D. and L. Chang (1983). “An Analysis of the New Jersey Formula for Including Investment Income in Property-Liability Insurance Ratemaking,” Journal of Insurance Regulation 1, 555–573.Google Scholar
  10. D’Arcy, S. and N. A. Doherty (1988). Financial Theory of Insurance Pricing (Philadelphia: S.S. Huebner Foundation, University of Pennsylvania).Google Scholar
  11. Fairley, W. (1979). “Investment Income and Profit Margins in Property-Liability Insurance,” Bell Journal of Economics 10, 192–210.CrossRefGoogle Scholar
  12. Ferrari, J. R. (1968). “A Note on the Basic Relationship of Underwriting, Investments, Leverage and Exposure to Total Return on Owners’ Equity,” Proceedings of the Casualty Actuarial Society 55, 295–302.Google Scholar
  13. Hill, R. (1979). “Profit Regulation in Property Liability Insurance,” Bell Journal of Economics 10, 172–191.CrossRefGoogle Scholar
  14. Modigliani, F. and M. H. Miller (1958). “The Cost of Capital, Corporation Finance, and the Theory of Investment,” American Economic Review 48, 261–297.Google Scholar
  15. Myers, S. and R. Cohn (1987). “Insurance Rate Regulation and the Capital Asset Pricing Model,” in J. D. Cummins and S. E. Harrington, eds., Fair Rate of Return in Property-Liability Insurance (Norwell, MA: Kluwer Academic Publishers).Google Scholar
  16. National Council on Compensation Insurance, (1987). The Impact of the Tax Reform Act of 1986 on Property-Liability Insurance Profits (New York: The Council).Google Scholar
  17. Pratt, J. W. (1964). “Risk Aversion in the Small and in the Large,” Econometrica 32, 122–136.CrossRefGoogle Scholar
  18. Sharpe, W. R (1970). Portfolio Theory and Capital Markets (New York: McGraw Hill).Google Scholar

Copyright information

© Springer Science+Business Media New York 1993

Authors and Affiliations

  • Franklin Allen
    • 1
  1. 1.Wharton Doctoral Programs, The Wharton SchoolUniversity of PennsylvaniaUSA

Personalised recommendations