Analysis of Surplus and Rate of Return Without Using Leverage Ratios

Modern risk theory has shown that the optimum risk-based surplus, once determined, can not be subdivided by line by state. It also follows that ratios of premiums to surplus (leverage ratios) do not exist which can by applied generally to property/casualty insurers in order to impute a surplus by line by state. Given that a rate of return can no be determined with respect to an allocation of surplus by line by state, the challenge presents itself as to how to determine the required rate of return for the industry and a particular insurer. The required rate of return must be based on a definition of rate of return measured by the annual change in surplus adjusted for stockholder dividends and capital paid-in. The required rate of return is determined from the general principles of economics, combined with an actuarial analysis of the structure and trends in the insurance industry. The required rate of return is different for stock and mutual insurers. The rate of return to the mutual insurer need only be enough to support the business to be written in the next year. The rate of return for stock insurers is based on the rate of return on book value necessary to attract capital, but the rate of return to the investor is based on the rate of return on market value, which is connected to book value by the market/book ratio. Keywords: Profit Factor, Rate of Return, Risk Regulation, Solvency