Financial Pricing Models for Property-Casualty Insurance Products

Insurance companies sell products without knowing what the ultimate costs will be. Moreover, in many cases the time between receipt of premium and the payment of claims could span many years. To manage the risk that companies have assumed, they need special tools to monitor the ongoing profitability of their products. In this paper we introduce one tool—retrospective analysis—to monitor profitability. Retrospective analysis is mainly concerned with incorporating all available information about a block of business to determine the current estimate of profitability and to attribute any differences to the appropriate sources. To illustrate the methods used in retrospective analysis we present a simplified but complete model of an insurance policy. We also introduce two economic accounting systems—the net present value system and the internal rate of return system—and analyze how emerging experience alters the profitability of our insurance policy. We pay special attention to quantifying the changes under both accounting systems.