The amount assigned to a policy should be a function of the risk associated with writing the policy, and will change over time as the risk changes. At first, the risk will include event risk. Examples of event risk include:
. Catastrophe risk
. Large loss risk (such as a fire at a major resort leading to a large number of suits and injured parties)
. High frequency risk as was seen in 1984 for WC, when an expanding economy led to an increased use of inexperienced workers and higher WC accident rate.
After the policy has "expired", the event risk will be essentially over, but the estimation risk is still there. Therefore the surplus requirement should drop but not go away once the losses move from the Unearned Premium Reserve to the loss reserve. There is still some "event" type risk in the IBNR reserve, as the events have occurred for policy trigger purposes but the details are not available for estimation purposes. Once the claim is reported, the estimation risk should decrease. Hence there is more risk in the IBNR reserve than in the case plus Bulk reserve. (NOTE: This line of reasoning can be found in an earlier paper by Bob Butsic, which dealt with profitability pricing loads.)
Given the above conceptual framework, surplus supporting a policy should start out at its highest at inception, and should gradually decrease as risk disapates.
Note that the above framework would NOT necessarily give you the same surplus loads by line. A WC policy for which losses take 10 years to pay out may have the same paid loss duration as a GL policy, but the risks could be totally different. The WC policy may have risk similar to an annuity, while the GL policy may incorporate the far greater risks of the tort system. The statement that surplus should strictly be a function of duration breaks down most obviously when life insurance products are considered. The surplus needed to support most life insurance reserves is typically much less than the surplus needed to support casualty reserves, even if the durations are similar.
After surplus is notionally assigned to a policy, the amounts assigned to historic policies can be stacked up to get the total assigned to the line at a point in time (i.e., the stock value). The faster the payout (or duration of reserve) the smaller the stock value will be in relation to the initial amount. This also implies that a start-up may have small initial capital requirements inherent in its balance sheet risks, but the capital requirements will steadily grow until it reaches a "steady state" or going concern level.
One useful concept for capital management is the velocity of capital. If the writer of a long tail line can eliminate the risk sooner after policy expiration, then that writer can release the supporting capital sooner, increasing capital velocity. If this could be done, then the overall capital requirements (surplus stock) would be much lower. The faster the capital velocity, the more flexible a company can be, and the slower the capital velocity, the more locked-in the company will be.
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