In the late 1970s, a number of economists applied the Capital Asset Pricing Model (CAPM) to the problem of pricing insurance contracts (e.g., Munch and Smallwood 1978, Fairley, 1979, and Hill 1979). The CAPM offered a means of systematically accounting for the investment income of insurance companies and an operational definition of the risk of underwriting. In 1977, William Fairley used the CAPM to build a model for the regulatory determination of profit margins in Massachusetts. The Fairley model has played a major role in rate hearings in Massachusetts since its introduction. It has become generally known as the “Massachusetts” model of profit regulation. The purpose of this chapter is to provide a critical appraisal of the use of the Fairley model as a regulatory tool. The theoretical foundations of the model are reviewed, several extensions of its basic specification are suggested, and additional empirical evidence on its reliability and stability is provided.
Keywords
- Risk Premium
- Systematic Risk
- Profit Margin
- Capital Asset Price Model
- Treasury Bill
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