Development To Policyholder Surplus

Development to policyholder surplus is the ratio of an insurer’s loss reserve development to its policyholder surplus. The development to policyholder surplus ratio shows whether a company is setting aside an appropriate amount of funds as loss reserves, and whether its policyholder surplus (an insurance company’s net worth) is overstated or understated.

The development to policyholder’s surplus ratio is often calculated over multiple time periods in order to see whether an insurer is consistently overstating or understating its reserves. If the development to policyholder’s surplus ratio is increasing from year to year, it may be an indication of the insurance company intentionally strengthening its loss reserves (overstating), while a decrease in the ratio may indicate that its reserves are being understated.

A policyholder’s surplus refers to the remainder of the assets of an insurance company, after deducting all of its liabilities to be able to provide the benefits expected to policyholders. It is the insurer’s net worth as shown in its financial statements. It is considered a financial support that protects policyholders against unexpected predicaments. Some companies include the following accounts in their policyholder’s surplus:

• Minority interests
• Stockholder’s equity comprising of common stock, other comprehensive income, additional paid in capital (APIC), and retained earnings; in which case the equity must not include minority interests
• An equity substitute, specifically hybrid capital

Regulators keep a close eye on insurance companies in order to ensure that they don’t run the risk of becoming insolvent, and one of the methods they use to monitor a large number of insurance companies is reviewing financial ratios. Insurers thus have an incentive to ensure that their ratios are not considered unusual, and will therefore, manage their loss reserves so as to not draw attention.

Understating loss reserves will result in more income from policyholders’ surplus, but less income from the reserve. The management of an insurance company’s loss reserve helps the company smooth out its income and draws less attention from regulators. Loss reserve errors (overstating and understating) are correlated to the income activities of the insurance company. Insurer’s involved in riskier investment activities are more likely to report more loss reserve errors.

Analyzing an insurance company involves reviewing its financial ratios in order to determine how the ratios have changed over time, as well as how the ratios compare to similar insurance companies. If a company’s development to policyholder’s surplus ratio is low, further analysis should focus on which lines of business are the most problematic. The ratio can be recalculated for each line of business.