CAS Exam 9 Spring 2019, Question 8
Study guide: Exam 9
Consider the following for a publicly-traded, monoline insurer:
- The insurer holds $50 million in surplus and writes $100 million in premium each year
- The expected loss and loss adjustment expense (LAE) ratio is 73%
- The underwriting expense ratio is 25%
- The insurer collects all premium and pays all underwriting expenses on January 1 of each year
- Losses and LAE are paid on December 31 of each year
- The insurer expects 92% of its business to retain each year
- The insurer's board of directors has decided to limit its investments to risk-free assets
- The company's target return on surplus is determined using the Capital Asset Pricing Model, and its CAPM beta is estimated at 1.25
- The expected return on the market portfolio is 12%
- The risk-free rate of return is 4%
Part a (3.25 points)
Calculate the duration of the insurer's total economic value if the company assumes a pricing strategy of setting the target return as the risk-free rate of interest plus a risk premium, such that the initial target return is the CAPM estimate.
Part b (0.5 points)
Briefly describe one advantage and one limitation of the insurer's pricing strategy.
Answer this question and see the worked solution