The fundamental charge of top managers in insurance companies is to monitor the surplus accumulated within the company and deploy it in the best possible directions. This means

Growing out of this surplus management process is the need for a system to distribute some surplus back to policyowners.

Because regulators understand the role of adequate capital in a company�s solvency, each state has minimum capital requirements. In most states these requirements take the form of a law specifying a minimum amount of capital for a company to become licensed in that state. Most states specify amounts between $1 million and $2 million, but a few like Arizona are considerably lower. These fixed-dollar requirements may soon be relegated to history. The National Association of Insurance Commissioners (NAIC) is finalizing new capital standards that vary depending on the level of insurance and investment risk maintained by individual companies. Although the individual states still need to adopt risk-based capital standards, the NAIC is already implementing the new standard by mandating that the standardized annual statement contain the information and ratios needed for risk-based capital evaluation.

Companies have always needed capital beyond the statutory minimum amounts. The amount of capital required depends on the type of business a life insurer writes and the willingness of the company�s owners and managers to take risks. The move by regulators toward risk-based capital requirements will, when fully implemented, impose a limit on how much risk the companies can choose to assume.

Traditionally most life insurance policies were issued for long terms and sold at fixed prices. These circumstances remove all possibility of future price adjustments and force an insurer to calculate its premiums conservatively. The degree of conservatism needed depends somewhat on the type of policies being sold. For example, a life insurance company writing participating insurance usually assigns its highest priority to the adequacy of gross premiums and can incorporate ample margins of safety into each basic assumption. The premiums of nonparticipating policies and policies paying market rates of interest must also meet the test of adequacy. However, contracts that include no provisions to adjust future costs in light of actual experience require careful consideration in order to develop premiums that will prove adequate over the long run and be competitive in the marketplace. The margins in such premiums will be narrower.

An insurance company invests its capital in financial instruments whose values move with interest rates and equities markets. The straight line labeled duration in figure 20-2 illustrates an asset whose value declines 25 percent (from $80 to $60) when interest rates rise from 6 percent to 8 percent.

When a life insurance company�s assets and liabilities move in the same direction and at the same pace in response to interest rate changes, the company is said to have immunized its portfolio against interest rate risks. Immunization means that a financial risk has been effectively neutralized�that is, the losses expected in one part of the business are offset by gains somewhere else when market conditions and interest rates change. For example, an immunized portfolio will offset a decrease in income due to lower interest rates by increases in the market value of the bonds held in that portfolio. This requires a very precise combination of bonds, mortgages, and stock of the appropriate durations to accomplish this balance and maintain it over a wide range of interest rate environments.

Two somewhat more sophisticated concepts measure the sensitivity of the insurer�s assets and liabilities to changes in interest rates. Duration is a representative time interval somewhat similar to the average holding period. Asset duration is the average time after requisition until assets (investments) mature; liability duration is the average period after policy issuance until a claim is paid. Optimal durations are affected by changes in interest rates. Liability durations also depend on events�like lapse, death rates, and policy loan demand�that are beyond the control of the insurer. Duration matching is an attempt to select asset durations that will closely match the cash flows from assets to the flows required by the insurer�s liabilities. Surplus duration is related to asset duration, liability duration, and the firm�s leverage. (These concepts are developed further in chapter 32.) Convexity measures the relative rate of change in the outside market and inside the company as interest rates change. As shown by the curved line in figure 20-2, price changes are much greater for lower interest rate changes than they are around high interest rates.

Understanding the confounding effects of interest rate changes permits management to protect a firm�s surplus during unfavorable economic and underwriting cycles by implementing safeguards, such as constraints on asset duration compared to liability duration. Ideally, the effect of external events on a company�s assets and liabilities will be matched in such a way that the company can remain solvent�preferably profitable�in a wide range of interest rate environments.

To maintain its financial strength a growing insurance company needs regular additions to its capital. This is particularly true during periods of rapid growth because the costs of establishing a new policy exceed the premium collected in the first year. The primary source of capital is internal and comes from favorable deviations of actual experience from assumed experience on seasoned life insurance policies. External sources of surplus include traditional capital markets and reinsurance.

The immediate result of profitable operations is an increase in the company�s surplus�that is, the company�s assets grow more than its liabilities. The primary sources of insurance gains are mortality savings, excess interest, and expense savings. The word savings, while somewhat misleading, refers to the amount remaining from more efficient and economical operations than were assumed when setting the premiums. Often the savings reflect margins built intentionally into the premiums to produce surplus. Interest earnings greater than the assumed rate usually contribute the largest portion of insurer gains for policies that develop a cash value. This includes the realization of capital gains�that is, the sale of an asset for more than its book value. Any transaction that increases assets more than liabilities or decreases liabilities to a greater extent than assets�voluntary policy terminations at early durations, for example�is a source of surplus. Supplementary features of the insurance contract, such as disability income and accidental death provisions, are examples of other sources of surplus.

Insurers also make assumptions about future expense levels (including anticipated inflation) when setting premium rates. If actual expenses remain lower than the assumed level this savings will contribute to surplus.

It is possible, of course, that a company will experience a loss with respect to one or more of the assumptions that enter the gross premium. For example, while AIDS deaths in the 1980s have not been sufficient in number to seriously affect the solvency of the life insurance industry, they have produced higher than expected mortality rates in some geographic regions and age categories, particularly for group insurance. These increased death rates, combined with generally declining interest rates during the early 1990s, make it much harder for life insurance companies to earn the profits anticipated.

Financing sources for noninsurance companies usually include debt and equity (the corporation issues bonds or stock). Theoretically these same options are available for some insurance companies. Insurance companies usually buy bonds, however, rather than issue them. The issuance of new stock, a common approach to raising capital, is available only to stock insurance companies. Because mutual companies do not have stock, they cannot raise capital by issuing stock.

In recent years converting a mutual insurance company to stock form has become an option for mutual insurance companies wishing to expand their access to capital markets. This process is called demutualization. In 1986 Union Mutual Life Insurance Company completed the first demutualization by a healthy life insurance company. The company�now called UNUM Life Insurance Company�raised about $580 million in new capital, roughly doubling its surplus. In 1988 a New York law permitting domestic mutual life insurance companies to convert to stock form took effect. This law addressed many formerly unanswered procedural and regulatory concerns. The Equitable Life Assurance Society of the United States became the first major company to use that law, announcing in the last days of 1990 its intent to pursue demutualization. Equitable obtained the required policyowner approvals for conversion during the first half of 1992. A French insurance company provided a large increase in surplus through the purchase of a large block of the Equitable stock.

Some new developments for insurers in the capital markets are (1) the issuance of unsecured corporate bonds by a mutual company and (2) the sale of part of real estate holdings to a newly formed real estate investment trust (REIT) sponsored by the insurer and financed by a public sale of the REIT.

Reinsurance can serve as a major source of (it is perhaps more accurate to say substitute for) capital in the insurance business. Some studies show that the availability of reinsurance diminishes the importance of organizational form (stock or mutual) that a company uses, primarily because it equalizes access to capital. Annual renegotiation of reinsurance treaties can be used to transfer more of a company�s financial risk to outsiders when adequate internal capital is not available to support that risk. From a financial perspective, the company buying reinsurance is "borrowing" the use of the reinsurance company�s capital. (See chapter 24 for a discussion of reinsurance arrangements.) While the analogy is imperfect, reinsurance serves a function similar to a line of credit. In the aggregate, the capacity of the insurance industry is enhanced by an amount up to the total capital available through the reinsurance market.