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📊 '''Capital asset pricing model (CAPM)''' is a foundational financial framework used within the insurance industry to estimate the expected [[Definition:Rate of return | rate of return]] on equity capital, serving as a critical input in pricing, [[Definition:Reserving | reserving]], [[Definition:Capital allocation | capital allocation]], and enterprise valuation decisions. While CAPM originates from general finance theory — developed by Sharpe, Lintner, and Mossin in the 1960s — its application in insurance is distinctive because insurers must determine the appropriate [[Definition:Cost of capital | cost of capital]] to charge against the [[Definition:Risk | risks]] they underwrite, and CAPM provides a disciplined, market-based method for doing so. The model expresses the expected return on an insurer's equity as the [[Definition:Risk-free rate | risk-free rate]] plus a risk premium proportional to the insurer's systematic risk, captured by the beta coefficient.

🔧 In an insurance setting, CAPM is applied in several interconnected ways. [[Definition:Actuary | Actuaries]] and financial analysts use it to set the target return on equity that an [[Definition:Underwriting | underwriting]] portfolio must achieve to justify the [[Definition:Capital | capital]] consumed, feeding directly into [[Definition:Risk-adjusted return on capital (RAROC) | risk-adjusted return on capital]] calculations and [[Definition:Premium | premium]] rate indications. When an insurer or [[Definition:Reinsurance | reinsurer]] evaluates whether a line of business is generating adequate returns, the CAPM-derived cost of equity serves as the hurdle rate. The model also appears in [[Definition:Embedded value | embedded value]] and [[Definition:Appraisal value | appraisal value]] calculations for life insurers, where future shareholder cash flows are discounted at a rate informed by CAPM. Estimating beta for insurance companies requires care, because insurer stock returns reflect both [[Definition:Investment risk | investment portfolio risk]] and [[Definition:Underwriting risk | underwriting risk]], and the relative weight of these components differs markedly between a [[Definition:Property and casualty insurance | property-casualty]] writer with volatile catastrophe exposure and a [[Definition:Life insurance | life insurer]] with long-duration, interest-rate-sensitive liabilities.

📐 Despite its ubiquity, practitioners in the insurance sector recognize CAPM's limitations and often supplement it with alternative approaches. The model assumes that all risk is captured in a single beta relative to a broad equity market index, which can understate the unique risks faced by insurance entities — such as [[Definition:Catastrophe risk | catastrophe tail risk]], [[Definition:Regulatory risk | regulatory risk]], or [[Definition:Longevity risk | longevity risk]] — that are not well-correlated with equity markets. Multi-factor models, the [[Definition:Fama-French model | Fama-French]] framework, and internal economic capital models are frequently used alongside CAPM, particularly in [[Definition:Solvency II | Solvency II]] jurisdictions where the regulatory framework encourages sophisticated risk quantification. Nonetheless, CAPM remains the starting point for most cost-of-capital discussions in insurance, and a solid understanding of its assumptions and outputs is expected of anyone involved in [[Definition:Capital planning | capital planning]], [[Definition:Mergers and acquisitions (M&A) | M&A]] valuation, or [[Definition:Reinsurance pricing | reinsurance pricing]] within the industry.

'''Related concepts:'''
{{Div col|colwidth=20em}}
* [[Definition:Cost of capital]]
* [[Definition:Risk-adjusted return on capital (RAROC)]]
* [[Definition:Capital allocation]]
* [[Definition:Beta]]
* [[Definition:Embedded value]]
* [[Definition:Solvency II]]
{{Div col end}}

Definition:Capital asset pricing model (CAPM) - Revision history

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