The Determination of Fair Profits for the Property-Liability Insurance Firm

Abstract

Although the property-liability insurance industry has been subject to price regulation for many years, surprisingly little research has been directed at producing valuation models of a property-liability insurance firm. Although property-liability price regulation has historically involved setting minimum prices to reduce the risk of insolvency, some commissions have begun to move toward setting prices more in the spirit of public utility regulation.¹ If, in an effort to promote efficiency, the working objective of such regulation requires the determination of prices that would prevail under competition, then regulation must be founded on some model of the costs of regulated firms. Under competition with free entry, prices just cover all economic costs, including the opportunity costs of investment by suppliers of capital, and a valuation model is required to explain how the market value of the firm, and therefore the cost of capital, reacts to changes in the prices it charges. Our objective in this chapter is to provide such a framework.