Black-Scholes Model and Its Application in the Insurance Industry

The Black-Scholes model, originally designed for short-term pricing of financial derivatives, has been explored as a quantitative method for the insurance industry for the evaluation of risks and premiums. In this paper, the usage of the model is explored systematically for investment-linked life insurance, catastrophe insurance, weather derivatives, and automobile insurance, analyzing its usefulness and limitations. Despite the model providing a formalized pricing framework, its assumptions of no market friction, volatility as a constant, and short-term application become challenging when the model is extended for long-term insurance contracts. According to the literature, the model can be further improved by modifying the volatilityfactors, including empirical findings, and using other stochastic models. Focusing on this aspect of derivative pricing in insurance, this research emphasizes the usefulness of finance derivative pricing principles for the insurance industry leading to product development and improved risk management as well as emphasizingthe interdisciplinary relevance of finance to the insurance industry. Whiledata nuances may not be applicable, further work is expected in making the novel model applicable for long determinants for various regulatory needs and for market-specific considerations such as health insurance, reinsurance, and insurance-linked securities.