Value and Capital Management: A Handbook for the Finance and Risk Functions of Financial Institutions

Chapter 25Risk Underwriting – From Technical Pricing to Value Maximization

It is important to ensure not only an adequate technical price but also an optimal commercial price. This chapter outlines considerations and techniques for ensuring adequate and optimal pricing.

Setting the appropriate price is one of the most important underwriting tasks. If the price is set too low, the company faces an opportunity cost at a minimum, leaving money on the table; in the worst case, it destroys value if pricing does not cover the technical cost of production. If the price is set too high, the firm again suffers an opportunity cost, being uncompetitive in the market; in the worst case, it destroys value due to adverse selection, with only the highest risk clients willing to pay the price.

Just like Goldilocks in the story of the three bears, an effective underwriting organization must set a price which is just right, neither too high nor too low. There are three activities needed to set the optimal price.

• First, understand the technical cost of production, including the cost of risk and expense loadings. In the absence of commercial decisions to subsidize some business, the technical price sets the “floor” or the minimum price which the company should charge. This is typically referred to as New Business RAPM pricing.
• Second, understand the optimal price, or the price which captures the most economic surplus. The ability to capture surplus depends on a variety of factors, including competitors' ...