Solvency Measurement for Property-Liability Risk-Based Capital Applications

Regulators have recently adopted a risk-based capital formula for property-liability insurers. This article develops practical methods for setting risk-based capital standards using the expected policyholder deficit as the solvency measure. The analysis considers the stochastic nature of insurance risk, using market valuation to remove measurement bias, and finds that a proper time horizon is the period between risk-based capital evaluations. The present value of the expected policyholder deficit is shown to be equivalent to a financial option implicitly given by the policyholders. Finally, covariance of risk elements is considered, deriving a simple square root rule.