One of the problems between insurance companies and consumer advocates (and some states) is a significant difference over how insurance prices should be calculated. In fact, the problem is not that they can not agree on the pricing model, but the underlying assumptions are in dispute.
In this series of two posts, I'll talk about the pricing problem. And while I will talk about two equations, one need not understand anything other than addition and subtraction to get the points I will make. Part I will cover the first equation and part II will cover the second equation.
Equation (1) above shows the basic pricing model. Prices are equal to the present value of losses plus company expenses, minus investment income allocated to the policy, and the cost of capital.
The present value of the losses are based upon the expected claims (known and estimated) that will come in during the policy year. There is some academic debate over the accuracy of these reported estimates, but it is not clear how important any error is for the typical company. Expenses are essentially labor expenses associated with underwriting, paying and adjusting claims, managing the investment portfolio or the costs of services like advertising and legal services the insurer uses. The term iI represents the investment return earned on surplus (the amount available to pay claims if needed). While technically possible to come up with some method of allocating surplus back to particular policy, I have never seen it done in practice for an individual policy, but at some level it must be done in order to determine whether a book of business is profitable. However, financial economists have tested aggregated models (with groups of policies) and shown that it occurs (See Cummins JRI 1991 for theory at JSTOR).
We have also seen a big debate about investment returns in the med mal arena by consumer advocates who claim the reason med mal prices increased dramatically during the early 2000s was because of poor investment choices by insurers. Poor investment choices mean a lower investment return, and thus higher insurance prices. (see e.g. here for Public Citizen's take). This is not really so much of an issue of poor investment management, but merely lower market returns as most of property-liability insurers' assets are in relatively high-quality /low risk bonds. In fact, if the consumer advocates position were the truly the case every time, the market had a downturn it would be due to poor investment management.
Finally, the last term rK, represents the cost of capital for the insurer. Equation (2) described in more detail in the next post, shows some of the factors which go into how much the insurer must pay its investors to attract investment into the firm. A more risky firm, all other things being equal, will have to pay more to attract capital. Everyone knows this and there is little debate about this in concept. Where the big debate is whether the firm is risky or not. Economists, for example, would states a high rate of return is associated with risk. Mr. Robert Hunter, a consumer advocate, thinks that profits are a sign of regulatory failure rather than risk. He also believes that insurance is a low risk investment, not deserving of a high cost of capital.
Others, like the firms which are leaving high risk areas of the country, believe that they can not attract capital as they can not afford to pay investors what they demand for investing in high risk investments. I think this is essentially Allstate's position and the rational for having a Federal Government intervention.
So the major question left unresolved is what is the appropriate cost of capital for insurers.
In part II of this nutshell, I'll talk about the determinants of the cost of capital (shown in equation 2) which include bankruptcy risk, line of business risk (LOB), geographic risk(GEO), legal and regulatory risk, managerial ability, diversification, and σ for uncertainty.