Risk Load and the Default Rate of Surplus

One of the biggest challenges facing the securitization of insurance risk is the translation of pricing techniques between the insurance and capital market worlds. At their heart the two worlds share similar purposes: assigning prices to uncertain future cash flow patterns. While the purposes are similar, historically the techniques and terminology have been somewhat disjoint. Widespread securitization of insurance results will require a manageable model to understand and price insurance risk in a capital market context. Ideally this model would also produce prices which were comparable to other securities available in the capital market. This paper introduces an insurance pricing model that translates aspects of corporate bond pricing – specifically default risk – to an insurance framework. It jointly addresses two favorite topics of casualty actuaries – allocated surplus and risk load, is well suited to DFA applications, and has been fully implemented in an Excel workbook that will be posted on the CAS Website.