What Is Development-to-Policyholder Surplus?
Development-to-policyholder surplus is the ratio of an insurance company'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.
The ratio also is an indicator as to whether its policyholder surplus (an insurance company’s net worth) is overstated or understated.
- Development-to-policyholder surplus is the ratio of an insurance company's loss reserve development to its policyholder surplus.
- Policyholder surplus is the difference between an insurance company's assets minus its liabilities.
- The development-to-policyholder surplus ratio shows if an insurer is setting aside an appropriate amount of funds as loss reserves.
Understanding Development-to-Policyholder Surplus
Policyholder surplus is the difference between an insurance company's assets minus its liabilities. Policyholder surplus helps to measure the financial health of an insurance company. Insurance companies set aside reserves in case they need to pay claims to their customers or policyholders.
An insurance claim is a request by a policyholder to be compensated for a financial loss from a covered event within the insurance policy. Policyholder surplus is considered an additional buffer of capital or money that could be used to pay claims if there aren't enough reserves.
Development-to-policyholder surplus helps to determine if an insurer has an excess amount of reserves or if the company has inadequate reserves. The development-to-policyholder 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 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. The surplus is also considered a financial support that protects policyholders against unexpected predicaments. Some companies include the following accounts in their policyholder’s surplus:
- Minority interests, which are interests or ownership of less than 50% in another company
- Stockholders' equity comprising of common stock, other comprehensive income, additional paid-in capital (or money paid from investors for stock), and retained earnings (or accumulated profit); however, the equity must not include minority interests
- An equity substitute, specifically hybrid capital, which might have elements of both a stock and a bond
Benefits of Development to Policyholder Surplus
Regulators keep a close eye on insurance companies 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 thus 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. Insurers 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 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.