The standard actuarial approach to ratemaking considers the need for profit by adding a loading in the rate. The selected loading may vary with investment returns and the amount of capital available and required to support the business, but it ultimately rests on an arbitrary requirement. An economist, by contrast, would typically derive the required rate by maximizing profit, constrained by the costs of production and other market conditions. This paper applies the economic approach of profit maximization to the pricing of insurance. The most common economic models of pricing behavior are not very useful for this task, because insurance sales generally involve unique buyers making discrete purchases, but this characterization is very well-suited to the emerging field of auction theory. In cases where insurers have some private information about risk quality, the results from the auction-theoretic approach are quite generally different from the traditional actuarial approach. Among other results, we show that the traditional actuarial approach to setting a profit load in rates can be self-defeating, resulting in lower profit than the specified load.
Justin Smith (Thu,) studied this question.