ALLOCATION OF SURPLUS.

One early attempt to make a pricing decision that explicitly reflects the value of surplus was the New Jersey Automobile Remand Decision in 1972. The Supreme Court asked then Commissioner of Insurance Robert Clifford to determine a fair profit provision for automobile insurance. Clifford determined both the fair return to the insurers' equity and the means of calculating that equity. After extensive hearings, Clifford found that only underwriting profits and the investment income earned from investing "policyholder supplied funds" were to be considered in ratemaking. A total return from these sources of 6% was appropriate on the "needed surplus", but only 1% was appropriate for "surplus surpus."

Clifford held that for automobile insurance, surplus was needed only up to one-half of written premiums, the excess was "surplus surplus." Using this reasoning, and a one-to-one industry average premium-to-surplus ratio he allocated both "needed" and "surplus" surplus in proportion to written premiums. Averaging the 6% and 1% returns, he found that a 3.5% return from insurance operations was appropriate then (3). In the years since the decision, Clifford's arithmetic has not been revised to reflect changes in eitherthe industry's capital structure or profit levels outside the industry, The 3.5% operating profit margin has been used as a fixed target (4).

This appears to have been the understanding of Clifford's decision from the first. Dineen, quoting ISO, "summed up Commissioner Clifford's decision" as:

"The effect of Commissioner Clifford's Determination is to establish a 3.5% after Federal Income Tax provision for underwriting profit from which investment income on policyholder-supplied funds, variable by line, must be deducted and that result then increased to a pre-Federal Income Tax basis for inclusion in the ratemaking formula."

Even though Clifford's allocation method has not attracted much attention, it is still worth examining. Clifford considered the surplus of the industry, but the technique is applicable to a single insurer.

(1)

The surplus allocated to a section of the insurer's book (S,) is found by multiplying that section's net written premium (WP,) by the ratio of the insurer's total surplus to total net written premiums.

This is shown for some groups of lines of insurance for 1985 industry totals in Table I.

Table I -- Surplus Allocated on Annual Written Premium

Line	1985 Written Premiums	Allocated December 31, 1985 Surplus
Auto Liability	$37,576,765	$18,388,661
Auto Physical Damage	25,519,959	12,488,512
Homeowners	14,473,884	7,082,977
Other Property	12,196,058	5,968,294
Workers' Compensation	19,263,729	9,426,947
Medical Professional	3,218,076	1,574,806
Other Liability	16,048,871	7,853,716
Miscellaneous	26,008,331	12,727,503
Total	$154,305,673	$75,511,417

One practical problem with this allocation is that changing the relative rate levels of the different sections changes the allocation. The amount of surplus allocated to a section decreases when the rates are decreased. This is counter-intuitive.

An alternative that avoids this problem is to allocate surplus on accident year incurred losses and loss adjustment expenses. However, this method has the problem of accurately estimating incurred losses during the accident year. If that estimate could reliably be made, surplus would hardly be needed.

Both allocation methods have several other practical problems. Neither method actually considers how much surplus is needed to support a section of the insurer's book. For example, a line of insurance that is no longer written may take many years to run off. No surplus would be allocated to a line running off because it has no written premiums and no accident year losses. However the danger of adverse runoff still limits the insurer's capacity and should be reflected in any allocation of surplus. Several major insurers were acutely aware of this in the 1980's as they experienced significant adverse development on Medical Malpractice reserves but had stopped writing this line in the seventies (5). Clearly, surplus funded the development, whether allocated to the line or not.

The opposite problem can occur in a rapidly growing section of the book. Too much surplus would be allocated there. Since these methods do not distinguish between different sections of the book to reflect special circumstances, such as the type of reinsurance, growth patterns, and reserve margins, they are extremely limited.

Either allocation formula relies on an annual flow (either premiums or losses) to allocate year-end surplus. This choice of a one-year history of the flow of funds is arbitrary. The choice also causes a peculiar factor in the allocation formula. A section's surplus is found in equation (1) by multiplying the section's annual written premium by the quantity (S/WP). S is valued in dollars, and WP is valued in dollars-per-year, so (S/UP) must be valued in years. This is a peculiar result to at least one actuary (6).

Calculation based on these allocations may not even need to consider surplus. Consider a pricing methodology that uses a return-on-net-worth calculation as a target.

(2)

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(3) R. E. Dineen, "An Early Look at the Decision in the New Jersey Remand Case" NAIC Pioceedings, 1974, Volume II.

(4) See, for example, recent N.J. private passenger rate filings.

(5) Source: A. M. Best Standard Computer Tapes, Schedule P.

(6) Charles Niles' remarks at the 1984 Casualty Loss Reserve Seminar (CLRS proceedings, p. 901.) addressed the premium-to-surplus ratio as a measure of leverage, but they should apply here as well.

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