20

Table of Contents

20
Surplus An Insurance
Company’s Capital
Norma Nielson and Donald Jones

Chapter Outline

MANAGING SURPLUS: Minimum Statutory Capital Requirements; The Need for Capital Beyond Minimum Requirements; Relationship to Investment Function; Sources of Surplus

DISTRIBUTION OF SURPLUS: Surplus to Meet a Company’s Capital Needs; Return for Financial Investment; Return of Premium Overcharge

ILLUSTRATIVE DIVIDEND COMPUTATION

GENERAL EQUITY OF THE DIVIDEND SCALE: Testing the Dividend Side; Other Issues

Preceding chapters stress the long-term obligations of life insurance companies. The premiums an insurer charges its customers cover the expected claims of those customers. The purpose of capital in any insurance company is to absorb unexpected upward fluctuations in claims. To meet long-term obligations, then, an insurance company needs capital that, in the terminology of insurance accounting, is called surplus.

Suppose, for example, that a medium-sized life insurer expects claims to be $7.5 million during an upcoming period. Uncertainties are inherent in any such projection. This means that the situation is more accurately represented by a distribution than by a single number. Figure 20-1 illustrates one possible distribution, where aggregate claims for each quarter are plotted on the horizontal axis and the probability that each level of aggregate claims will occur is depicted on the vertical axis. The company expects claims of $7.5 million, but losses in excess of $16 million are theoretically possible, although highly improbable. Sophisticated statistical analysis beyond the scope of this book suggests that for this specific distribution the company should not expect aggregate claims to exceed $9 million in a bad year.

FIGURE 20-1
Distribution of Quarterly Claims

An epidemic or natural disaster that produces bad life insurance results in one quarter is also likely to affect subsequent quarters. Life insurers are particularly vulnerable to changes in claims caused by an epidemic or natural disaster because many of their contracts involved fixed premiums that cannot be adjusted upward.

One way to explain capital adequacy is by expressing how many quarters of bad experience a company’s financial position can absorb. Based on the statistical analysis mentioned above, this insurer could have actual claims exceed expected claims by $1.5 million in a bad quarter. A firm with exposures illustrated by figure 20-1’s distribution and capital of $3 million can remain solvent only through two consecutive poor quarters. An insurer with $6 million in capital can be confident of its ability to remain solvent through four consecutive poor quarters, and so forth.

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