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Application
Massachusetts rate regulation has been a very fertile ground for analyzing the capital
structure and profit requirements for insurance companies. This paper is another
important contribution to that history. The authors give an objective and consistent
measure of the amount of Surplus which is subject to this double taxation. The authors
show that marginal default values can be an allocation base for Surplus in rate
regulation calculations. They argue that it should be, for well-founded reasons. But they
do not, and cannot, show that it must be.
The authors provide two strong arguments for using their marginal default values. First,
marginal default values have the high merit that they “add up”. However, allocations
based on premiums, losses, expenses, historic profit provisions, aggregate amount of
limits provided, or policy counts also add up and have some plausible arguments as
allocation bases. Second, and what is more important, the authors consider an
environment where all insurance is sold on a “retail” base, subject to guarantee funds.
Regulators can view the marginal contribution to default risk as the true cost to society
of providing coverage, and thus a gauge of the fair price to charge to insureds. Not
argued by the authors, but in a simpler view, regulators might also feel that committing
more Surplus to a product provides a higher quality of insurance protection and
therefore merits a proportionally higher profit.
Reassuringly, marginal default risks and capital commitments certainly move together.
Products that contribute more to the potential default of a company, or to a larger default if it should happen, are greater commitments of insurers, and do merit higher
rewards from regulators. While other allocation bases are possible, this reviewer feels
that the approach suggested by the authors is a very reasonable one, and one that
regulators should strongly consider, when an allocation is required.
A recent trend among U.S and other insurers has been the movement to off-shore
domiciles. In these situations, many insurers are exempt from income tax. They are,
instead, subject to excise tax which can be as little as 1% of premiums for the riskbearer,
when exposure is sent off-shore in the form of reinsurance. Understanding the
cost of an off-shore company’s commitments does not require a Surplus allocation.
But at least today, most primary insurance provided in the United Sates is written by
U.S.-based companies who are subject to income tax on their investment returns.
Moreover, regardless of tax status and domicile, insurers’ Surplus has other costs. For
example, insurers cannot freely invest in the asset mix which they view as optimal.
They also find difficulty in moving capital in and out of their companies without
regulatory approval and delay and rating penalties.
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