Surplus - Concepts, Measures of Return, and its Determination

Insurance is perhaps the industry most intensely scrutinized from a financial perspective, with an abundance of financial data prepared to satisfy the many and varied regulatory requirements imposed upon it. Yet this financial reporting produces some of the most controversial and contradictory financial conclusions depending upon the methodologies employed and the data used. A good part of the difficulty is created by the nature of the insurance product itself, which requires payment by many for a product or service for which few benefit, and further for which the cost will not be known for some time in the future. It is this multi-year dimension which makes it most difficult to properly match revenue and expense, the first step in measuring profit, and which further makes it difficult to identify the amount of surplus needed to support the business being written. Both profit and surplus together are needed to measure the total rate of return. This paper discusses the limitations of present calendar period oriented financial reporting, and introduces the concept of a calendar period balance sheet viewed as the sum of underlying accident period balance sheets. The multi-year dimension to surplus and its linkage to liabilities over time is demonstrated. Measures of rates of return on surplus inherent in Internal Rate of Return and Net Present Value discounted cash flow models are discussed and the conditions under which the returns are equivalent are demonstrated. The importance of the balance sheet perspective, usually overlooked by cash flow models, is emphasized. A methodology is presented which provides a means of determining a benchmark surplus requirement needed to control the probability of insolvency that can result from underwriting and investment volatility.