An Evaluation of Surplus Allocation Methods Underlying Risk Based Capital Applications

The allocation of policyholder's surplus is a common element of financial analysis models, including models used in solvency regulation, risk-based capital determinations, profitability calculations and ratemaking. Because the allocation method can significantly affect financial estimates by insurance line, it is important that the selected allocation method be reasonable. Four allocation methods are tested. Allocation Method I is based on the method imputed in the current NAIC profitability calculations. Allocation Method II is based on net earned premiums only. Allocation Method III is based on the sum of the mean adjusted unearned premium reserves plus the mean loss and loss adjustment expense reserves. Allocation Method IV is based on the by line premium to surplus leverage norms recently prescribed in California. The premise underlying the evaluation of each allocation method is that the best method is the one which produces internally consistent results, if applied consecutively year after year. To be internally consistent, the tested allocation method should produce minimal differences for each line of insurance between the beginning-of-year surplus for any selected year and the year-ending surplus for the first previous year. Profit Factor/Rate of Return/Risk