A discrete time option pricing model is used to derive the “fair” rate of return for the property-liability insurance firm. The rationale for the use of this model is that the financial claims of shareholders, policyholders, and tax authorities can be modeled as European options written on the income generated by the insurer’s asset portfolio. This portfolio consists mostly of traded financial assets and is therefore relatively easy to value. By setting the value of the shareholders’ option equal to the initial surplus, an implicit solution for the fair insurance price may be derived. Unlike previous insurance regulatory models, this approach addresses the ruin probability of the insurer, as well as nonlinear tax effects.
“Price Regulation in Property-Liability Insurance: A Contingent Claims Approach,” (with Neil A. Doherty), Journal of Finance, Vol. 41, No. 5, December 1986, pp. 1031-1050 (reprinted in Foundations of Insurance Economics, Georges Dionne and Scott Harrington, editors (Norwell, MA: Kluwer Academic Publishers, 1991)), pp. 572-591).