10/01/2008

Pricing for Systematic Risk

Pricing for Systematic Risk

Frank Schnapp
Director of Actuarial Analysis and Research
National Crop Insurance Services, Inc.

ABSTRACT

In recent years, financial methods have emerged as the dominant approach for establishing insurance profit loadings. Financial theory suggests that prices should reflect systematic risk only, with no reward for diversifiable risk. This principle is applied to the pricing of insurance exposures actively traded in a secondary market. The resulting Systematic Risk Pricing Model differs from the Capital Asset Pricing Model in that it determines the price rather than the rate of return for each exposure. In order to reconcile the two pricing models, the amount of capital invested in a security in the Capital Asset Pricing Model is reinterpreted as the price for the exposure. Under the Systematic Risk Pricing Model, the price for the exposure is determined without regard for the insurer's cost of capital. In this method, an exposure's rate of return represents the profit margin, that is, the expected profit for an exposure in relation to its price. Due to the inconsistency of the CAPM with this result, the interpretation of CAPM rate of return as the market capitalization rate used to discount fiature income to present value is abandoned. An in-depth examination of the CAPM identifies a number of conceptual errors with the model, the most serious of these being that the CAPM substitutes the variability of the price of the exposure over time for the true risk of the exposure. A mathematical derivation of the CAPM from the Systematic Risk Pricing Model is presented to identify the faulty assumptions underlying the model.

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