Economic Valuation Models for Insurers

Recently much attention has been given to the approaches insurers undertake in valuing their liabilities and assets. For example, in 1994 the American Academy of Actuaries created a Fair Valuation of Liabilities Task Force to address the issue [see Doll et al. (1998), Reitano (1997), Babbel (1997, 1998b), Babbel and Merrill (1996), and Merrill (1997)]. In 1997, the Academy established a Valuation Law Task Force and a Valuation Tools Working Group to investigate the various valuation approaches extant and to recommend the models best suited to the task.Much of the literature on valuation has focused on the strengths and shortcomings of the various models. Some of the work has addressed larger questions, but in our view it is useful and necessary to provide a taxonomy of approaches and evaluate them in a systematic way in accordance with how well they achieve their aims.In this paper we focus primarily on the economic valuation of insurance liabilities, although we do address some valuation issues for assets. We begin by defining insurance liabilities in Section I. Next, in Section II we discuss the criteria for a good economic valuation model and provide a taxonomy of valuation models in Section III. In Section IV, we examine insurance liabilities in the context of this taxonomy and identify the minimum requirements of an economic valuation approach that purports to value them adequately. An illustration of the application of a modern valuation model is given in Section V. We conclude in Section VI by discussing some limitations of our analysis and offer some recommendations for implementation.