Application of the Option Market Paradigm to the Solution of Insurance Problems

The Black-Scholes option pricing formula from finance theory is consistent with the assumption that the market price of the underlying asset at any future date is lognormally distributed with time-dependent parameters and can be shown to be a special case of both a more general option model and a familiar actuarial function used in excess of loss applications. This insight leads to an understanding of the similarity between options and certain insurance concepts. Because insurance and finance have developed separately, different paradigms are used by the practitioners in each field. When these paradigms are shared, a new perspective on risk management, product development, and pricing, especially of insurance and reinsurance, emerges.