Solvency

Abstract Studies of an insurer's solvency have shifted from an early focus on mathematical ruin theory to the use of computer simulation models. This has been stimulated by the development of increasingly sophisticated regulatory capital requirements and a move to establish consistent international standards for these. The development of advanced approaches for determining capital requirements, based upon an insurer's internal models, has stimulated firms to examine their economic capital requirements and expand their risk management programs, thereby focusing the firm's attention on its continuing solvency. The business of insurance is essentially stochastic in nature. Many factors affecting an insurer's experience and financial standing, including insurance claims, aspects of policyholder behavior, interest rates, and equity values and rates of return, are best treated as random variables. Insurance companies price their products and provide for claims on the basis of their many years of experience. Pricing and the provision for policy liabilities are usually based upon the expected levels of that experience. To allow for unfavorable variations in future experience from assumed values, specific margins are usually added to the expected rates. However, experience in any given year may vary considerably from average or expected levels. Premiums and policy liabilities or reserves may become insufficient to guarantee payments to policyholders and to provide for an insurer's continued operation. The insurer's solvency, its ability to meet all of its financial obligations, may be threatened. Since an insurer's fundamental product is its promise to pay benefits when circumstances warrant, it will usually seek to maintain the probability of its continuing solvency at an extremely high level. It is therefore necessary for an insurer to have sufficient financial resources, in addition to the value of its liabilities, available to survive the “rainy day”, that is, to absorb unexpectedly high losses and maintain its solvency. These additional funds are the company's capital.