Statutory Surplus: Computation, Pricing and Valuation

The development of financial pricing models for insurance products and the advent of risk-based capital requirements have led to an increasing focus on capital. This study note explains the differences between statutory surplus and invested capital and the implications for actuarial pricing and valuations. When insurance products were priced to a 5% underwriting profit margin, some states mandated that investment income be considered, often by simple investment income offset procedures that reduced the underwriting profit margin for the investment income earned on policy holder supplied funds. These procedures did not consider capital or surplus. Insurers are now using return on capital models, for pricing and performance measurement. The pricing models vary in their definitions of capital, whether statutory surplus, GAAP equity, economic surplus, or invested capital. Similarly, actuarial valuations may use GAAP earnings, statutory earnings, or cash flows. The valuation results differ sharply, and proper valuation relies on an accurate assessment of the capital supporting insurance operations. The idiosyncrasies of statutory accounting complicate the relation between statutory surplus and invested capital. For example, the statutory income statement shows net income earned during the current year. One might supposed that last year’s surplus plus this year’s net income should equal this year’s surplus, but there are half a dozen other adjustments, such as the change in non-admitted assets or the change in the provision for reinsurance, which are direct charges or credits to surplus. In contrast, the surplus figure on the balance sheet is total assets minus total liabilities, with no adjustment for direct charges or credits to surplus. The sign of the income statement adjustments is also confusing, since an increase in non-admitted assets causes a decrease in policyholders’ surplus. Some readers wonder: “Why should an increase in assets, of whatever sort, lead to a decrease in the worth of the company?” This study not traces the computation of statutory surplus, along with the difference from GAAP equity; contrasts statutory surplus (and GAAP equity) with invested capital; and adds the capital in the policy holder reserves with the capital required by statutory regulations to determine the capital supporting the insurance policy.