The Theory of Insurance Risk Premiums - - a Re-examination in the Light of Recent Developments in Capital Market Theory

The premium calculation principle is one of the main objectives of study for actuaries. There seems to be full agreement among the leading theoreticians in the field that the insurance premium should reflect both the expected claims and certain loadings. This is true for policy, risk or portfolio. There are three types of positive loadings: a) a loading to cover commissions, administrative costs and claim-settlement expenses; b) a loading to cover some profit (a cost-plus approach) ; and c) a loading for the risk taken by the insurer when underwriting the policy. The administrative costs can be considered a part of "expected gross claims". Thus, the insurer's ratemaking decision depends on his ability to estimate expected claims (including costs) and on the selection of a fair risk loading. The main concern in the literature is the appropriate measurement of the risk and the exact loading formula. BOI-rLSIANN [1970, ch. 5] and others identified four possible principles of risk loading, namely, the expected value principle, the standard deviation loading, the variance loading, and the loading according to the principle of constant utility. Various studies point to the advantages and disadvantages of these principles and also examine some additional loading forms--semi-variance, skewness, etc. (e.g., BOHLSIANN [1970], BENKTANDER [1971], BERGER [1972 ], I~URNESS [1972], BERLINER [1974], BERLINER and BENKTANDER [1976 ], BOHS{AN [t976], COOPER [1974], GERBER [1975] and others). Despite different pleferences in choosing the appropriate loading calculation principle, all seem to agree that the risk loading must be positive, since, otherwise, the firm would just have to wait for its ruin, that is bound to come sooner or later, according to risk theory. The purpose of this article is to re-examine the appropriate principle of premium calculation in light of the recent developments in the theory of finance and especially in the theory of capital market equilibrium. These developments may suggest a new point of view and raise a few questions regarding the loading rules.