Effects of under and Overevaluations in Loss Reserves

Abstract

It has been suggested that the amount of policyholders' for property and liability insurance companies should be sufficient to cover adverse underwriting results, declines in asset values, and underevaluations of loss reserves. While the first two variables have received considerable study, essentially no data have been collected and analyzed to measure the significance of loss reserve developments. Thus, the primary purpose of this paper will be to study the significance of underevaluations of loss reserves upon policyholders' surplus; to compare the significance of underevaluations of loss reserves with that of unfavorable underwriting results and decreasing asset values; and to examine the interactions among the three variables. The status of policyholders' is one of the key variables in determining financial strength in property and liability insurance companies. Policyholders' relates to financial strength by preserving a solvency. Mayerson states that a company's capital and is its ultimate guarantor of solvency.' Until recently, adequate levels have been measured in the United States on a qualitative basis supplemented by rough rules-of-thumb.2 The recent formations of numerous holding companies have accelerated the need for a more precise measure of adequacy. Through the Dan R. Anderson, Ph.D., is Assistant Professor of Business in the Graduate School of Business at The University of Wisconsin. The author wishes to acknowledge the financial support from the Wisconsin State Insurance Department. This paper was submitted in February, 1971. 1 Allen E. Mayerson, Ensuring the Solvency of Property and Liability Insurance Companies, Insurance, Government, and Social Policy, ed. Spencer L. Kimball and Herbert S. Denenberg (Homewood, Illinois: Richard Irwin, Inc., 1969), p. 181. 2 See Roger Kenney, Fundamentals of Fire and Casualty Insurance Strength, (4th ed.; Dedham, Massachusetts: The Kenney Insurance Studies, 1967). use of the holding company vehicle, excess can be transferred from the insurance firm to the holding company in order to enjoy less stringent investment requirements and hopefully increased profitability. Kip reports that nearly $1.6 billion of capital has been taken from a dozen property and liability companies in the past several years.3 In 1969 alone, $1 billion in left the property and liability insurance industry via this route.4 These transfers present no inherent problems of maintaining solvency, as long as only excess amounts of are transferred. The principal difficulty is that a precise method for determining how much of a is excessive has not been determined. In an attempt to define this problem, the Special Committee on Insurance Holding Companies differentiates between required a d surplus surplus. 3Richard deR. Kip, How To Get Capital Out of the Property Liability Insurance Business, CPCU Annals, Vol. 23, No. 3 (September 1970), p. 244. 4 Jeremy Main, Why Nobody Likes the Insurers, Fortune, Vol. LXXXII, No. 6, (December 1970), p. 119.