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Analysis of Surplus and Rate of Return Without Using Leverage Ratios

Insurance officials can take action if either the risk-based surplus is deficient, or the rate of return is deficient. The required
risk-based surplus and the required rate of return on the surplus must be in balance.
The proposed approach for measuring return was to take national figures and to allocate them proportionately to get by line
by state results, which were combined with the state experience to get a profit or rate of return as a percent of premium.
Surplus was imputed by state using estimated premium to surplus ratios (leverage ratios) to get a rate of return by line for the
state as a percent of surplus. The problem is that the insurance business has a wide range of risks, some of which have no
relation to the premium. The true premium to surplus ratios can vary widely between insurers writing the same lines of
business.
The NAICs response to measure profit by line is the IEE, which attempts to measure profitability by matching calendar year
losses, expenses, and income allocated by line to annual premiums. The mistake made here is to relate the results to surplus
by allocating surplus by line, investment income on surplus by line, or by using leverage ratios. The IEE will never be a
useful regulatory tool until theres a proper matching of losses, expenses, and investment income with annual premiums.
The regulatory process demands a rate of return calculated by line by state.
To calculate a rate of return, the profit must be compared to a base. When the base is surplus, the surplus is imputed by line
by state using leverage ratios, or is subdivided by line in proportion to either premiums, reserves, or a combination.
For a given insurer, theres an appropriate level of risk based surplus, based on the 7 sources of risk:
1) Underwriting risk adequacy of the premium to pay losses & expenses
2) Investment Income Risk whether or not the expected investment income is realized
3) Investment Asset Risk leverage of invested assets to surplus
4) Reserve Risk leverage of total reserves to surplus
5) Social Risk inflation, changes in law, changes in frequency due to the economy
6) Catastrophe Risk
7) Credit risk.
Many of these risks arent related to the particular lines. There are risk interactions between the lines of business, and even
between the various sources of risk. The appropriate level of risk based surplus is determined as a whole, and will vary
between insurers of the same size. An appropriate aggregate surplus is unique to each insurer depending on all the sources of
risk, which interact. The premium to surplus ratios of insurers may vary widely. An appropriate aggregate premium, once
determined, cannot be subdivided or allocated by line by state, nor by year.
Were left with 2 meaningful numbers:
1) The required surplus of the insurer
2) The required marginal surplus for a specified change in assets, liabilities, or premium.
There are no fixed premium-to-surplus ratios by line which are appropriate for all insurers.
An insurers actual surplus will be more or less than the surplus imputed to the insurer based on the leverage ratio, yet the
investment income is based on the actual surplus. When the actual surplus is subdivided by line, the resulting allocation will
most likely be too low for the particular line and state, and if surplus cant be allocated, investment income on surplus cant
be allocated.
Since leverage ratios cant be used, how can we measure return? First, we must properly measure income.
The 1921 profit formula stated that:
1) A reasonable underwriting profit is 5% of premiums plus 3% for conflagrations, and
2) No items of profit or loss connected with the so-called banking end of the business should be taken into
consideration
This held until 1970, where an NAIC study refuted it. The new study recommended that income from all sources be
ascertained and considered, including income on capital funds. The study concluded that income should be determined from
an investors perspective.

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By 1984, interest rates had risen to the point that investment income had become the primary source of net income for
insurers. A new NAIC study concluded that the total return approach was most appropriate in regulating property/casualty
firms. There were still some problems:
1) Significant items of income were excluded, such as unrealized capital gains, policy fees, and sometimes realized
capital gains
2) Approach suggested relied on an allocation by line by state in order to set a by line by state rate of return. Weve
already shown its not meaningful to do this
3) Theres an implication that the proper rate is a constant, when in reality, its a dynamic target
Net income as used in the annual statement is just a tax calculation. The true income is the annual increase in the net worth
of the business.
Let S equal the beginning statutory surplus of the insurer, and dS equal the increase in surplus over the year, including
dividends and excluding additional paid-in capital. Then dS/S is the total rate of return.
Its rare to see the advocating of expanding incomes definition to be defined in terms of change in surplus, but this is the only
true definition of economic income and the only definition which truly includes ALL sources of income. Net unrealized
capital gains and losses are real gains and losses from an economic and business point of view, even though they add
volatility to a calculated rate of return.
If surplus is measured on a GAAP basis, find this from the Statutory Surplus:
Statutory Surplus
+ Unauthorized Reinsurance
+ Excess Statutory Reserves
+ Prepaid Expenses
+ Non-Admitted Assets
+ Special Reserves
- tax on prepaid expenses
- tax on unrealized capital gains
= GAAP Net Worth
Its often assumed that GAAP net worth is proportional to SAP surplus by a fixed factor (usually 1.15-1.20). In this event,
dS/S is the same whether S is based on GAAP or SAP. Any change in the accounting definition of surplus will affect both
the numerator and the denominator, so the total rate of return is almost independent of the definition of surplus.
The Supreme Court has said that income or return to the equity owner should:
1) Be commensurate with returns on investments in other enterprises having corresponding risks, and
2) Be sufficient to attract capital and maintain credit.
This is the fair and reasonable test for rate of return. The only definition of income which can be used with this test is the
change in net worth. We can only determine whether or not the rate of return is adequate in the environment, we cant put a
definite number on it
Adequate:
Industry attracts Capital
New Companies are being formed

Inadequate:
Stockholder dividends > Capital inflow
Little competition or withdrawing companies

There must also be a perception that a fair and reasonable rate of return will be obtainable in the future.
The law requires only the fair and reasonable opportunity to make a fair and reasonable rate of return. Inefficient insurers
shouldnt be protected, and efficient insurers shouldnt be punished. The rate approval process is not intended to guarantee
a fair and reasonable rate of return for each insurer.
Unlike stock insurers, mutuals cannot raise capital, and they dont pay stockholder dividends. However, the fair and
reasonable test can still be applied to the insurers.
Stock insurers tend to be focused on larger loss and expense reserve lines (mainly commercial). Mutual insurers focus on
personal lines, requiring smaller loss and expense reserves. This is a direct result of the inability to raise capital: they must
utilize a risk averse strategy. Mutual insurers pay higher policyholder dividends, because these dividends act as a cushion
against adversely high losses, since theyre not paid in the event of high losses. Both types of insurers treat policyholder
dividends as an expense item, so they dont come out of surplus, like stockholder dividends do.
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Any increased risk must be supported by additional surplus, so the profit provision must provide for future:
1. Expense and Claims Inflation
2. Increase in Aggregate Reserves
3. Increase in Demand
4. Dividends to Stockholders
Mutual insurers only need to increase surplus by enough to cover 1-3. The profit provision must provide for this. Since
theres no consideration required for a return on capital or stockholder dividends, the rate of return analysis is easier for
mutual insurers.
Notes on Rate of Return Components (table 5 in paper):
Different lines of business have different inflation rates, therefore different rate of returns
Demand increases each year as the population increases, the surplus of the industry must expand to support this
Loss and expense reserves may increase faster than net written premiums, due to increased litigation, increased
settlement delay, and increased demand for liability coverages. This increase must be supported by a proportional
increase in surplus
Stock insurers can obtain the surplus required to support inflation, new business, and the increase in reserve by
attracting new capital and by increasing retained earnings
Even though the profit provisions for the 2 types of insurers are different, the profit provision and the rate of return can be
determined by examining the actuarial and financial economics of the business. A fair and reasonable rate may vary by type
of insurer, and by the lines the insurer writes.
If the insurance surplus stops growing, then the retained return on capital would drop, and the dividends to stockholders
would rise. Dividends to stockholders, the retained return on capital, and the surplus paid-in are all constantly adjusting to
maintain the competitive equilibrium rate of return.
A discounted cost flow model is formulated in terms of an annual change in the investment of investors, and the resulting rate
of return is equivalent to dS/S. Most models include an estimate of the growth in EPS, which is equivalent to keeping some
capital for the increase in demand. However, the models dont include all of the dynamics of the industry, and they dont
explain rate of return requirements for mutuals.
The proper measure of the required rate of return is dS/S, which will vary between stock and mutual insurers and vary
depending on inflation, interest rates, the national economic cycles, underwriting cycles, catastrophes, and the dynamics of
the insurance business.
Mutual insurers must be considered separately in any rate of return analysis. The typical mutual is an insurer that was created
out of a market crisis, and provides coverage to a select group of insured. The primary goal may not be profit maximization,
but to provide availability of a particular coverage. Underwriting standards may be looser, and a greater reliance may be
placed on policyholder dividends. The analysis up to this point provides a good basis for testing the reasonability of the
profitability. Other tests may involve comparing the expense ratios and the loss ratios with other insurers writing the lines.
The greater demand on stock companies to keep capital utilized has led to higher levels of underwriting leverage. This higher
leverage makes stock companies more susceptible to failure. Mutual companies have, on average, less underwriting
leverage, leading to fewer insolvencies. This helps to explain why a uniform leverage ratio approach is not feasible.
A stock and a mutual insurer can charge the same rate for the same coverage and still have different rates of return. The
mutual insurer can charge a lower rate than the stock insurer, and still not write all of the business.
The required rate of return for mutuals depends only on the prospective inflation rate of the claims which are expected to
occur, the relative growth in reserves and liabilities, and the expected growth in exposures. The existence of stockholders
adds another dimension. The tests which involve attraction of capital and comparison with other industries are tests which
are not well suited to the examination of a rate for an individual stock insurer. Examining the rate of return for individual
stock insurers involves looking at the ratio of market to book value of the stock.
The return which the investor actually sees is the rate of return on the market value of the stock. The market to book value
ratio is often considered in connection with a merger/acquisition.
The ratio of the actual return on market value and return on book value should equal the market value to book value ratio.
The return on book value is approximately the rate of return (dS/S) and is the rate of return to the insurer and is also a

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measure of past performance. The rate of return on market value is the rate of return which the investor is demanding in
order to invest in the company. The ratios for individual companies vary widely.
For stock insurers, the stock market will price the stock to get the competitive rate of return based on the investors
assessment of the risk/return relationship. Since the shares of the insurers are publicly traded, the investors are, by definition,
receiving a fair and reasonable rate of return based on the risk/return relationship.
Does this mean that the rate of return on book value (dS/S) is fair and reasonable? This is the regulatory issue we face.
Since stock insurers are competing in the capital marketplace, and capital can be added or withdrawn, economic theory would
argue that the rate of return on capital must be competitive equilibrium rate of return.

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