Investment Income and Profit Margins in Property-Liability Insurance: Theory and Empirical Results

Abstract

The present analysis applies the capital-asset pricing model (CAPM) of contemporary financial theory to derive risk-adjusted rates of return that the capital markets require of stock property-liability insurers. The required profit margins in insurance premiums for the major property-liability lines that are consistent with these rates of return are derived using estimated multiquarter cash flows for premiums and costs. These margins have been used by the Massachusetts Commissioner of Insurance in rate decisions or rate reviews for all the major property-liability lines and for medical malpractice insurance. They represent an effort to bring the consideration of insurer profits within a framework of modern financial theory. A distinctive feature of the margins developed here is that, because they do not depend upon actual investment results for insurers’ portfolios, they offer a nonintrusive regulatory solution of the long controversy over the use of investment income in insurance rate setting.¹