THE FUNCTIONS OF SURPLUS.

Each of these payments were funded out of the insurer's surplus. Funding these payments must also be a purpose of surplus. So we now have:

Insurance is only practical when the insurer faces exposure to loss from a large number of independent causes. To the policyholder, this means that coverage is only available if there are many other distinct risks. Maintaining confidence in the insurer's solidity among consumers, producers end regulators is eseential to attracting a broad book of independent business. A key component in this endeavor is maintaining adequate surplus. While, and indeed since, surplus provides for certain or contingent unfunded payments, it also serves to maintain confidence in the insurer. This represents a seventh function of surplus.

Table VI -- Functions of Surplus

1.	To provide protection againat unexpected increases in losses and expenses.
2.	To provide protection against adverse reserve runoff.
3.	To provide protection against downward asset value fluctuations.
4.	To provide protection against all other adverse financial contingencies.
5.	To fund business written at a lose,
6.	To fund dividend payments when income cannot, and
7.	To maintain confidence in the insurer among producers, regulators and consumers.

Knowing what surplus does, and having seen the problems in some allocation techniques, we can now develop

PRACTICAL CONSIDERATIONS FOR MAKING MEANINGFUL ALLOCATIONS.

These functions of surplus are diverse, but a meaningful allocation method must consider them. This is because the underlying purpose of allocating surplus is to make economic decisions that consider how each portion of the insurer‘s book restricts its ability to write other risks. Each of these seven functions (and perhaps others that the author did not consider) contribute to limitations on the insurer's capabilities and must therefore be considered in making these decisions or in making a meaningful allocation of the insurer's surplus. This conclusion provides the first consideration:

1. The allocation must consider each function that surplus is performing.
Other considerations follow from the intended purpose of the allocation and from what we mean by an allocation.

The definition of allocation used in this essay only requires that the sum of the amounts that are allocated does not exceed the total of the account being allocated. That is, four apples cannot be allocated into three apples and two apples. However the definition does not forbid allocating four apples into one apple and two apples (and leaving an unallocated apple) or into five apples and a negative apple (by lending between the allocated pieces). However, the surplus of a multi-line insurer must meet more demanding standards than apples do.

If the allocated amounts of surplus are less than the total amount of surplus, part of the surplus is not allocated. (This follows from the exhaustive, mutually-exclusive definition of the sections.) The unallocated part of surplus is still available to support the writings of the insurer.

Ignoring this piece of surplus tiould understate the ability of the insurer to write more business and distort economic decisions based on the perception of that ability. So the amount of surplus allocated must be no less than the total surplus of the insurer. This requirement and the definition of allocation, produce the second practical consideration:

2. The sum of the amounts of surplus allocated to the various sections of the insurer's book must be exactly equal to the insurer's total surplus.

By cancelling policies it is possible to write a negative amount of premium. In a similar situation when an the insurer cancels policies after the last surplus evaluation date, the equity in the unearned premium reserve that became income on cancellation may exceed the maximum adverse runoff on the reserves and other adverse contingencies. So it may be possible to look back and determine that the worst outcome on a group of cancelled policies is still a gain. Negative surplus equal to the minimum gain could be allocated to the cancelled policies, allowing an equal amount of additional, positive surplus to be allocated to other portions of the insurer’s book.

The idea of negative surplus on an active portion of the insurer's book doesn't make as much sense. Surplus exists partly to convince potential policyholders of the solidfty of the insurer's promise of coverage. A zero or negative amount cannot perform that function. The surplus allocated to a section of the insurer's book records the limitations that that section puts on the ability of the insurer to write additional business. The reason for making an allocation is to make reasonable decisions that recognize the limitation of the insurer's resources. Negative amounts allocated to a section of the book that present an exposure to loss would not express this exposure to loss. It must therefore distorr any decisions that rely on it.

So a meaningful allocation could not allocate a non-positive amount of surplus to a section of the book that presents any probability of unfunded loss. This becomes our third practical consideration:

3. The amount of surplus allocated to any section of the insurer's book that presents an exposure to loss must be positive.

Since each section of the insurer's book that presents an exposure to loss limits the insurer's ability to write additional business, we have seen that sensible allocations of surplus will record that exposure to loss by assigning surplus. Moreover, if at a given level of probability, one section presents a higher maximum adverse outcome than another section, then the first section should be associated with a greater amount of surplus available to fund the adverse outcome. The amount of surplus available to fund adverse outcomes excludes the amount allocated, to fund under-priced business or unfunded dividends. This constitutes the fourth practical consideration:

4. Among sections, the amount of allocated surplus, less amounts that fund under-priced business or unfunded dividends, must increase as any section's exposure to unfunded losses increases.

These four considerations only examine the practical requirements that an allocation method must meet which are dictated by the nature of the economic questions the allocation is intended to answer. Other requirements come from the nature of the decision-making process.

Decisions must be made for the present and future. Data are only available for the past, and are not always available for the recent past. If a decision that uses a surplus allocation is to be informed and reasonable, the allocations must be estimatable from old results: they must be relatively stable. They must not change substantially due to small changes in the capital structure of the insurer or in its results over the near term.

If the allocations are to be valuable, the allocation must be available in situations where consensus is lacking. If a consensus were' available then pricing, performance levels, profitability and solidity could be assessed without resulting to allocations of surplus. The formulas used to make the allocations must be explicit:.objective and justifiable. These two observations complete the list of practical considerations (14)

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(14) No attempt is made here to show that these practical considerations constitute sufficient standards. Indeed, because of the philosophical and practical problems discussed earlier, the author feels that an allocation of the surplus of a multi-line insurer to lines of insurance need not be possible.

Marc Anthony's remarks cited at the beginning of this essay prefaced a eulogy that lauded Caesar in life and death. However, this essay contains no hidden praise. The author's intent is, as stated, to demonstrate practical and philosophical problems with making an allocation of surplus, and to propose alternatives to making allocations.

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