Consistent Measurement of Property-Casualty Risk-Based Capital Adequacy

This paper is a review and case study of Butsic's expected policyholder deficit (EPD) framework for measurement and maintenance of risk-based capital adequacy for property-casualty insurance companies, the promise of which is that long term solvency protection can be achieved by periodic assessment and adjustment of risk-based capital using a consistent and short time horizon, e.g., one year, for risks on both sides of the balance sheet. Using a common one-year EPD risk measure to assess all risks, the case study examines the exposure to capital exhaustion during the period 1999 through 2004 arising from 1) U.S. Commercial Auto Liability accident year 1999 underwriting and reserving and 2) investment in the stocks comprising the S&P 500. The case study results indicate that NAIC and rating agency risk-based capital requirements for Commercial Auto Liability are significantly higher than necessary to meet stated solvency objectives and much higher than those demanded for common stock investments. That disparity probably exists for other lines of business as well. The consistent measurement of all time-dependent risks described in the paper is relevant not only to risk-based capital applications but to enterprise risk assessment and management as well.