Statutory Returns on Surplus and the Cost of Equity Capital

The statutory return on surplus for the insurance industry has averaged slightly over 10% during the 1970's and 1980's. Estimates of the cost of equity capital during the same period have averaged about 16%. The cost of capital and the firm's accounting return may differ for various reasons. For instance, company growth may depress the statutory return on surplus in several ways. First, acquisition and underwriting costs are expensed when incurred, but no recognition is given to the "equity" in the unearned premium reserve (the "deferred acquisition costs"). If the insurer is growing, this equity increases over time, statutory earnings may be understated, and the return on surplus may be depressed. Second, loss and loss adjustment expenses are held at undiscounted values on the statutory balance sheet. If the insurer is growing, the "unrecognized interest discount" in the loss reserves increases over time, statutory earnings may be understated, and the return on surplus may be depressed. These two effects account for about 2.16 points of return, or slightly over a third of the discrepancy between the statutory return on surplus and the cost of equity capital. These adjustments to statutory returns allow a more accurate assessment of insurer profitability.