Solvency Risk

This paper presents a new perspective on three basic financial quantities: assets, liabilities and surplus. The new perspective is developed through a re-examination of the fundamental concepts inherent in these quantities. This re-examination clarifies the difference between the concept and the various rules commonly used to establish their numerical value. With the benefit of this clarification, an alternate approach to the development of surplus is presented. The traditional actuarial/accounting paradigm creates surplus by first discounting and summing individual asset and liability cash flows to establish individual asset and liability values. These asset and liability values are then summed to establish a surplus value. The alternate paradigm first sums all anticipated annual itemized cash flows to establish a vector of projected net total cash flows. These total cash flows are then discounted and summed to develop a surplus value. The new paradigm does not create a new type of surplus. It creates a new way to calculate surplus. And the new way in which it calculates surplus allows and encourages the notion of variability. The purpose of developing this new paradigm is to create a framework in which surplus variability can be recognized, defined and studied. By incorporating variability, the new framework allows a precise definition of solvency risk. In summary terms, solvency risk is defined as the degree of variability in surplus, where surplus is a function of its scenario (uncontrollable future events) and strategy (controllable future events) determinants. The definition is shown to be constent with the common understanding. of solvency risk and provides a workable guide for comparing alternative management initiatives in terms of their solvency optimization potential.