This paper develops an economic basis for selecting the solvency measure, and additionally determines how the measure can be calibrated to produce optimum capital. By maximizing policyholder welfare, a reasonable goal for regulation and corporate governance, I show that the optimal capital amount can be established by assessing the policyholders’ perceived value of the expected default relative to the insurer’s cost of holding capital. This optimality is achieved while allowing insurers a competitive rate of return.
The result is that the proper solvency measure is adjusted ruin probability, where the probability distribution of losses or assets is modified to reflect policyholders’ risk preferences. The optimal level of the adjusted ruin probability is uniquely determined by the frictional cost of holding capital. With this foundation, I also show that the subadditivity property of a coherent risk measure is an unnecessary criterion for evaluating insurance solvency.
Under the policyholder welfare framework, the level of the adjusted ruin probability standard will vary by degree of policyholder risk aversion, interest rates, insurer income tax rates, amount of guaranty fund protection and other factors not considered in applying the above conventional solvency measures. I also discuss the relationship between the minimum regulatory level of capital and the insurer’s optimal level.
Keywords: Solvency risk measures; policyholder welfare; optimal capital; adjusted probability distribution; certainty-equivalent losses; frictional capital costs; exponential utility; stochastic mean; subadditivity.
