PROCEEDINGS May 15, 16, 17, 18, 2005 - Casualty Actuarial Society

ARCHITECTURE FOR RESIDENTIAL PROPERTY INSURANCE RATEMAKING 503Cost of CapitalThe cost of capital held to protect the insurer against infrequentcatastrophic events that produce losses far in excess of thelong-term average for the peril must be considered in ratemaking.The held capital may be internally generated, borrowed frominvestors, or “rented” from reinsurers. Most insurers capitalizetheir cat risk using a combination of sources, with the largestoften being reinsurance. Reinsurance may be available from privatesources, which include a market-determined cost of capitalin their premium, and/or public sources, which generally do not.Musulin and Rollins [15] contains a description and comparisonof private and public property cat reinsurance options in Floridaand a breakdown of the reinsurance premium as follows:where:P R = Ĉ ¡ R(Ĉ)+ + T (3)Ĉ = expected direct cat losses (i.e. modeled gross annuallosses);R(Ĉ) = expected net retained cat losses (determined by reinsuranceprogram design); = charge for cost of capital (a.k.a. reinsurance risk load);T = transaction costs (such as brokerage and reinsurer administrativeexpenses).A spectrum of approaches exists for efficiently reflecting thecost of catastrophic events in ratemaking, such as:1. Treatment of the entire reinsurance premium (appropriatelyallocated to line) as a fixed expense in ratemakingand consideration of only non-cat and retained cat lossesin the loss portion of the experience ratio. This methodwould be most appropriate for a heavily reinsured com-