I can memorize the surplus aid formula but I am having difficulty understanding it intuitively. How is it aiding the surplus and what is the explanation for what we are calculating?
First, let's review the term "Policyholders' Surplus" or PHS:
Policyholder Surplus — the difference between an insurer's admitted assets and liabilities—that is, its net worth. This figure is used in determining the insurer's financial strength and capacity to write new business.
Now, if an insurer is "low" on surplus, they may not be able to absorb unexpected losses, which is not a good situation and may invite scrutiny of regulators. For that reason, this insurer may seek what's called "surplus aid".
Surplus can be aided by increasing assets, or decreasing liabilities, or some combination that results in a net increase in surplus. One common way of doing this is to purchase reinsurance. When a portion of liabilities is transferred to a reinsurer, these liabilities are removed from an insurer's balance sheet so surplus tends to increase.
Of course, premiums are ceded to the reinsurer as well, and there is the cost of the reinsurance treaty and these would tend to also cause assets to decrease. But if a reinsurance treaty is structured appropriately, this decrease in assets would be more than offset by the decrease in liabilities and the result is a net increase in surplus. In other words, the surplus has been aided.
The purpose of this ratio is to determine how much aid the insurer's surplus is receiving. If the insurer's surplus is receiving too much aid, this is not a good indicator of health of the insurer.
If you look at the formula you'll see that:
The surplus aid ratio tends to be higher when the original PHS is lower to begin with.
The surplus aid ratio will be higher when commissions from the reinsurer are higher. (This makes sense because the benefit to the insurer is higher when the commissions are higher.)
The surplus aid ratio will be higher when reinsurance premiums are lower. (This makes sense because it means the cost of transferring the liabilities is lower so the insurer doesn't have to pay out as much in assets to get the benefit.)
If you understand the above comments, that should be sufficient to get you through any potential exam question on this topic.
Page 139 of Financial Reporting also has a good explanation of Surplus Aid and explains a calculation of a previous exam problem that I found tricky about Surplus Aid
Is this what you're referring to? This was on page 141 of the edition I'm looking at. (The page numbers in the CAS Financial Reporting text depend on when you downloaded it from the CAS website. They published 2 editions that have different-sized fonts and one edition has 50 more pages than the other.)
Yes, that's it! I was going off of the page number in the physical copy I bought from the CAS website. Maybe it has a different font size like you mentioned?
Comments
First, let's review the term "Policyholders' Surplus" or PHS:
Now, if an insurer is "low" on surplus, they may not be able to absorb unexpected losses, which is not a good situation and may invite scrutiny of regulators. For that reason, this insurer may seek what's called "surplus aid".
Surplus can be aided by increasing assets, or decreasing liabilities, or some combination that results in a net increase in surplus. One common way of doing this is to purchase reinsurance. When a portion of liabilities is transferred to a reinsurer, these liabilities are removed from an insurer's balance sheet so surplus tends to increase.
Of course, premiums are ceded to the reinsurer as well, and there is the cost of the reinsurance treaty and these would tend to also cause assets to decrease. But if a reinsurance treaty is structured appropriately, this decrease in assets would be more than offset by the decrease in liabilities and the result is a net increase in surplus. In other words, the surplus has been aided.
The purpose of this ratio is to determine how much aid the insurer's surplus is receiving. If the insurer's surplus is receiving too much aid, this is not a good indicator of health of the insurer.
If you look at the formula you'll see that:
If you understand the above comments, that should be sufficient to get you through any potential exam question on this topic.
Page 139 of Financial Reporting also has a good explanation of Surplus Aid and explains a calculation of a previous exam problem that I found tricky about Surplus Aid
Is this what you're referring to? This was on page 141 of the edition I'm looking at. (The page numbers in the CAS Financial Reporting text depend on when you downloaded it from the CAS website. They published 2 editions that have different-sized fonts and one edition has 50 more pages than the other.)
Then on page 142:
Yes, that's it! I was going off of the page number in the physical copy I bought from the CAS website. Maybe it has a different font size like you mentioned?