What Constitutes a Reasonable 
 Underwriting Profit 
 
 and 
 
 The Method of Determining 
 Same 
 
 NATIONAL BOARD OF FIRE UNDERWRITERS 
 
 ACTUARIAL BUREAU COMMITTEE 
 
 NEW YORK 
 1920 
 
Certain queries were embodied in resolutions 
 presented at the annual meeting of the National Con- 
 vention of Insurance Commissioners held in Hartford 
 in September, 1919, which resolutions were transmitted 
 to F. C. Buswell, President of the National Board of 
 Fire Underwriters under date of October 25, 1919, by 
 Honorable Joseph Button, Commissioner of Insurance 
 of the Commonwealth of Virginia and Chairman of the 
 Committee on Fire Insurance of the Commissioners’ 
 Convention. 
 
 The following constitutes a partial answer to the 
 questions thus propounded. 
 
5. / S 
 
 5G5,\ 
 
 FIRST 
 
 ^ WHAT CONSTITUTES A REASONABLE UNDER- 
 WRITING PROFIT? 
 
 An equitable regard for the investors who furnish Reasonable 
 the capital for this particularly hazardous business 
 would indicate that 5^ is the minimum percentage 
 which can he regarded as “a reasonable underwriting 
 profit.” This has already been recognized as equitable 
 by several states. 
 
 The Method of Determining Same (Whether Paid or 
 Earned Premiums, and Paid or Incurred Losses 
 and Expenses) ? 
 
 The laws of the several states very properly require Earned 
 that the portion of the PREMIUMS unearned he set Premiums, 
 aside in a reserve fund until such earnings accrue. Since 
 the company’s surplus is augmented only by the portion 
 of the premiums earned and removed from such reserve 
 and only the portion earned can be treated as an ele- 
 ment in computing the profit result as shown in the 
 annual statements made in accordance with such legal 
 requirements, companies should not he expected to re- 
 turn the full amount of premiums paid in, but only such 
 amount as is earned. 
 
 As to LOSSES, the principle is even more obvious Incurred Losses. 
 that incurred losses, and not paid, is the only proper 
 basis. A simple and convincing illustration of this prin- 
 ciple is afforded by the case of a company which suffers 
 a conflagration loss, or losses of considerable magnitude, 
 just prior to the end of the year. In reporting on a paid 
 basis such losses would not appear at all, owing to the 
 fact that there had not been sufficient opportunity to 
 V. adjust and pay them before the end of the year; con- 
 sequently, the result would be wholly inaccurate and 
 misleading. 
 
 ^ q 
 
 <=^ ^ 
 
 ^ 49976 
 
Incurred 
 
 Expenses, 
 
 EXPENSES incurred are usually also paid, but at 
 the end of the year, there are quite large sums particu- 
 larly of federal, state and other taxes which companies 
 have incurred hy doing business for the year then end- 
 ing, hut which are not payable until some date in the 
 following year, and which have not even been de- 
 termined when the year closes. Necessarily, reserves 
 have to be set up for items of this character, whether 
 taxes or otherwise, and to this extent incurred expenses 
 should be allowed for. In other words, we endorse the 
 method of the Insurance Commissioners as laid down for 
 the underwriting exhibit of the Convention Annual 
 Statement Blank; namely, earned premiums against in- 
 curred losses and expenses. 
 
 Experience 
 
 Period. 
 
 The Proper Number of Years on Which to Base Such 
 Calculation? 
 
 Insurance as a business is governed by the law of 
 averages, and one year’s experience is insufficient to 
 establish a dependable experience. The laws of such 
 states as have recently made enactments on the subject, 
 as for example, Arkansas and Colorado, have recognized 
 that a five-year period is the minimum over which a 
 dependable experience of underwriting profit or loss 
 can be established. 
 
 Federal Taxes 
 
 SECOND 
 
 WHETHER IN SUCH CALCULATIONS INCOME 
 AND EXCESS PROFITS TAXES ARE TO BE 
 ALLOWED AS AN EXPENSE? 
 
 Federal income and excess profits taxes are among 
 the heaviest burdens as to expense under which the com- 
 panies labor. Some states also have enacted taxes of 
 like character. It is clear that no determination of 
 profit can be made which ignores these very heavy items 
 of expense. It is idle, as weU as unjust, to compute a 
 
 4 
 
paper profit from which further deductions must be 
 made before an actual profit is available as a result of 
 doing business, to the parties whose capital is hazarded 
 in the enterprise. All deductions of losses and expenses 
 should be made before the production of any figure re- 
 garded as profit. 
 
 No corporation organized for profit and depending 
 for its existence upon a reasonable return to its stock- 
 holders from its operations could continue if due credit 
 were not given for all costs of operation which go to re- 
 duce the amount of its net income, upon which its return 
 to stockholders is predicated. 
 
 THIRD 
 
 WHETHER ANY ITEMS OF PROFIT OR LOSS CON- 
 NECTED WITH THE SO-CALLED BANKING 
 END OF THE BUSINESS SHOULD PROPERLY 
 BE TAKEN INTO CONSIDERATION? 
 
 Stock fire insurance is carried on by companies hav- 
 ing a capital stock divided into shares contributed not 
 by the policyholders in any part but solely by the stock- 
 holders. The business is managed by directors chosen 
 solely by the stockholders and in which the policyholder 
 has no interest or voice. Every policyholder in such a 
 company enters into his engagements with the company 
 as such without regard to any other policyholder. He 
 pays the premium upon his policy not for the purpose 
 of insuring any other person but solely as a consideration 
 for his own insurance and the indemnity he is to receive 
 in case of loss. The company receives the money as its 
 own and holds it as its own and may do with it what it 
 sees fit, except as it is restrained by some statute. It is 
 wholly immaterial to the insured what the company does 
 with the money or what disposition it makes of it, pro- 
 vided it remains solvent and is in position at all times to 
 pay any contractual obligation. 
 
 Non-ParticipO' 
 
 tion. 
 
 5 
 
Accounting 
 Treatment of 
 Investment 
 Earnings. 
 
 Distinction 
 Between Profits 
 From Opera- 
 tions and Re- 
 turns from 
 Investments. 
 
 Underwriting 
 Subject to 
 Charges in 
 Favor of 
 Investments. 
 
 There is nothing in the organization or conduct of 
 a stock company which gives the right to a policyholder 
 to expect any participation in the earnings of the com- 
 pany, whether it he investment earnings or otherwise, 
 and there is no substantial difference, so far as partici- 
 pation is concerned, between the actual return of a part 
 of such investment earnings and the application of a 
 part of the investment earnings to the reduction of rates. 
 
 Stockholders are entitled to a profit for assuming 
 the hazard against loss, this being the particular enter- 
 prise the company engages in. If they also put up large 
 sums of money which are held invested, return on such 
 investments has nothing to do with the results of under- 
 writing. If the stockholders choose, they could invest 
 the money in the same securities without subjecting 
 their investment to the chance of loss due to the hazards 
 of the insurance business, and without going to the 
 trouble and expense of conducting the insurance busi- 
 ness. Clearly there would be no incentive to engage in 
 the business of insurance if this income which they 
 could obtain from their investments in any case is not 
 recognized as a rightful return to the stockholders irre- 
 spective of what they gain or lose from their contracts 
 of indemnification against loss. Furthermore, if the 
 underwriting end of the business is to be credited with 
 the proceeds of the investment branch, it will be found 
 that there are a number of conditions, penalties, and 
 handicaps under which the investment branch of the 
 business is placed for the benefit of and to promote the 
 business of the underwriting branch. The sums with 
 which underwriting will have to be charged will prob- 
 ably exceed the sum with which it will be credited by 
 beginning a series of charges and credits between the 
 two branches of the business, which would also create 
 a confusion in terms. 
 
 6 
 
The argument that income from funds comprising 
 unearned premium reserve is underwriting income, rests 
 upon the premises that while earned premiums alone 
 are considered in computing underwriting profit or 
 loss, full premiums are actually collected in advance; 
 and such collection in advance of the time when earned, 
 of premiums on the steady flow of business, maintains 
 constantly in the hands of the companies, funds of many 
 millions of dollars which yield an income to the com- 
 panies, but for the use of which they do not have to pay. 
 
 But should losses from bad investments be charged 
 to underwriting result? Should declines in market 
 values be charged to underwriting result? Doubt- 
 less the advocates of the plan suggested by question 
 “THIRD” will answer — “no. If you lose the money the 
 policyholder prepays you, that has nothing to do with 
 underwriting. The selection of bad investments is a 
 hazard of the investment end of the business. The 
 choice of investments which decline in value is a hazard 
 of the investment department. These gains or losses 
 have to do with skill in choosing investments and have 
 nothing to do with underwriting.” Thus, they would 
 wish the companies to credit the underwriting result 
 with the regular earnings from the investments, whereas 
 losses, if any, would be charged to the investment 
 result. 
 
 But are not the regular earnings also a matter of skill 
 in choosing investments? And if so, why should earn- 
 ings which accrue from the use and application of such 
 skill be credited to underwriting result? Why should 
 underwriting result be concerned with what companies 
 do with the advanced premiums? That has nothing 
 to do with the relation of premium to hazard, which is 
 the essence of underwriting. A company may invest 
 such funds where they yield 6%, or may leave them in 
 a hank where they draw but 2^, or may invest them 
 where there is promise of a good return, but where, 
 owing to any one of many possible causes, the invest- 
 
 Affirmative 
 
 Premises. 
 
 Investment 
 Losses and 
 Depreciation. 
 
 Interest 
 
 Earnings. 
 
 7 
 
Companies* 
 
 Position. 
 
 Relation of 
 Premium and 
 Hazard. 
 
 Income from 
 Reserve Fund- 
 How to 
 Ascertain. 
 
 ment fails to make any return. Why should underwrit- 
 ing result reflect any one of these conditions which re- 
 sult from the exercise of investing judgment? Why, 
 in short, should the question of the use of money enter 
 into a problem properly involving only the relation 
 between the premium and the hazard for which it is 
 charged together with the expense incident to doing 
 the business? 
 
 Even if the advocates declare their willingness to 
 admit the use of gains and losses, and advances and de- 
 clines in the market values, along with the regular 
 earnings from funds comprising the reserve and contend 
 that all these elements to the extent that they affect 
 unearned premium reserve funds should be allowed for 
 in computing underwriting result, still the companies 
 object for two reasons: 
 
 (1st) They hold that underwriting is a matter 
 involving on the one hand the premium; on the other 
 the expenses of transacting the business and the hazard 
 of loss. Interest is not received except as funds are 
 loaned or invested, and the loaning and investment of 
 funds has no connection with the relation of premium 
 and hazard; 
 
 (2nd) If they were to use the income from reserve 
 as a credit to underwriting, how should it be ascer- 
 tained? Which investments comprise the reserve and 
 which the surplus? Possibly the method would be as 
 follows: Add the gross assets at the beginning and end 
 of the year, and average them. Add the reserve at be- 
 ginning and end of year, and average it. Ascertain the 
 proportion which the average reserve bears to average 
 gross assets. Assign to underwriting result such propor- 
 tion of all income from interest, dividends and rents, all 
 profit on sales or redemption of assets, all increases in 
 market values. Charge to underwriting result such pro- 
 portion of losses on sales or redemption of assets and 
 all declines in market values. 
 
 If a company’s gross assets are $21,000,000 and its 
 
 8 
 
reserve $9,000,000, by this plan approximately .4285 of 
 all investment income gains and losses would be carried 
 to underwriting result, as follows: 
 
 
 
 Under- 
 
 writing 
 
 Invest- 
 
 ment 
 
 Interest, Dividends and 
 
 Total 
 
 Result 
 
 Result 
 
 Rents $750,000 
 
 Gains on Sales and Re- 
 
 $321,375 
 
 $428,625 
 
 demption 
 
 Losses on Sales and Re- 
 
 8,000 
 
 3,428 
 
 $324,803 
 
 4,572 
 
 $433,197 
 
 demption 
 
 Declines in Market 
 
 150,000 
 
 64,275 
 
 85,725 
 
 Values 
 
 240,000 
 
 102,840 
 
 $167,115 
 
 137,160 
 
 $222,885 
 
 The result demonstrates the absurdity of this pro- 
 cedure; since actual investment income is here so arbi- 
 trarily cut asunder and partially assigned to “underwrit- 
 ing result,” as to render the maintenance of any dis- 
 tinction between underwriting and investment results 
 a mockery; for the two would he inextricably inter- 
 tangled, and neither phrase would thereafter have any 
 significance agreeing with its apparent meaning. 
 
 It is generally understood with sufficient clearness 
 that when a new company enters business, the amount 
 which it is required to set aside in the reserve fund as 
 unearned, together with the expense disbursements it 
 is obliged to make without waiting to earn the pre- 
 miums, and such losses as it incurs very greatly exceed 
 the sum of the premiums written and woidd create an 
 impairment of capital did not the stockholders pay in 
 enough surplus to tide it over this condition until such 
 time as a sufficient earned surplus can he created, which 
 usually requires several years, perhaps ten. 
 
 Illustration of 
 
 Anomalous 
 
 Result. 
 
 Confusion in 
 Terms. 
 
 Effect of 
 Reserve 
 Requirements 
 On New 
 Company. 
 
Illustration. 
 
 Effect of 
 Reserve Re- 
 quirements on 
 Established 
 Company. 
 
 For example, a new company writes premiums of 
 
 $ 1 , 000 , 000 . 
 
 It is fair to assume the reserve for such first year 60^Oi 
 
 or $600,000 
 
 Expenses 40% 400,000 
 
 Losses 25% 250,000 
 
 $1,250,000 
 
 Impairment 250,000 
 
 Premiums assumed to he composed of the following: 
 Annual . $720,000 50^ reserved . $360,000 
 3 years. 180,000 5/6 “ . 150,000 
 
 5 years. 100,000 9/10 “ . 90,000 
 
 $1,000,000 $600,000 
 
 ■It is not so generally realized that the same condi- 
 tions necessarily exist with the oldest and strongest com- 
 panies, having the largest surplusses, in respect of the 
 writings of each successive year. After paying the year’s 
 expenses, setting aside the required reserve and settling 
 the losses on current writings only, the premiums from 
 such current writings will invariably he exceeded. How, 
 then, is this deficit made up, as regards an established 
 company? Not by the sums taken out of the reserve 
 as earned on business written in previous years, reserves 
 for which were set up in the year when written. The 
 company is entitled to carry these sums over to its 
 earned surplus as fast as the fact of their having been 
 earned removes them from the reserve. It is out of this 
 earned surplus itself that each company must advance 
 the funds necessary to make up the deficit resulting from 
 the combination of reserve, expense and losses attaching 
 to each successive year’s business put on the hooks. 
 Therefore every company, no matter how strong, must 
 suffer a depletion in its surplus in favor of the reserve 
 in respect of the business put on the hooks in the cur- 
 rent year, from that which the surplus would otherwise 
 be, and an accurate accoimting between the underwrit- 
 ing and investment departments would require that 
 underwriting be charged and investments credited with 
 
 10 
 
the use of the funds which each year are thus borrowed 
 from the surplus. 
 
 To correct any impression that 60% is too high a 
 reserve to assume on current writings in view of the 
 fact that the reserve funds of established companies 
 frequently run about 53% of their outstanding premi- 
 ums, the following table will demonstrate that these 
 elements are totally different and these percentages not 
 at all irreconcilable: 
 
 For example, in case the proportions as to term 
 business were in detail as displayed in the foregoing, 
 the record for three years would be as follows: 
 
 Premiums Reserve Illustration. 
 First year, per detailed exhibit. . . .$1,000,000 $600,000 
 
 Second year, annual business runs 
 
 off 720,000 
 
 Reserve runs off as follows: 
 
 Annual 1/2 
 
 .$360,000 
 
 
 
 3 years 1/3 
 
 . 60,000 
 
 
 
 5 years 1/5 
 
 . 20,000 
 
 
 440,000 
 
 
 
 $ 280,000 
 
 $160,000 
 
 Second year’s writings (same pro- 
 
 
 • portions as first year) 
 
 
 1,000,000 
 
 600,000 
 
 
 
 $1,280,000 
 
 $760,000 
 
 Third year — Annual business runs 
 
 
 off 
 
 
 $720,000 
 
 
 Reserve runs off : 
 
 
 
 
 1st year writings : 
 
 
 
 
 Annual 
 
 
 
 
 3 years 1/3 
 
 . $60,000 
 
 
 
 5 years 1/5 
 
 . 20,000 
 
 
 
 2nd year writings: 
 
 
 
 
 Annual 1/2 
 
 $360,000 
 
 
 
 3 vears 1/3 
 
 . 60,000 
 
 
 
 5 years 1/5 
 
 . 20,000 
 
 
 $520,000 
 
 
 
 $ 560,000 
 
 $240,000 
 
 Third year’s writings 
 
 (same pro- 
 
 
 portions as previous years) . . . . , 
 
 . 1,000,000 
 
 600,000 
 
 11 
 
 $1,560,000 $840,000 
 
Percentage of 
 
 Premiums 
 
 Reserved. 
 
 Capital Held 
 at Disposal of 
 Underwriting 
 Operations. 
 
 Actual 
 
 Company 
 
 Experiences. 
 
 Proportion of reserve to outstanding premiums at 
 this point .538, arrived at, however, hy setting aside 60% 
 in each successive year, showing that this percentage of 
 each year’s business is not too high to reflect the ex- 
 perience of companies. In fact, the experience as shown 
 hy the following actual figures, relating to a certain com- 
 pany’s business for the year 1917, shows a still higher 
 per cent of reserve, namely 67.9%, which would indicate 
 the theoretical reserve of 60% per the preceding figures 
 is probably too low. 
 
 Consideration should also be given the amount of 
 capital trusted out, not at interest, in unpaid agent’s 
 accounts (the amount of which as shown in the annual 
 statement is not a fair average as companies, generally, 
 make a special effort to collect balances before the 
 end of the year), amounts of capital advanced in pay- 
 ment of losses before due, etc. In short, there are many 
 elements which invested capital could charge against 
 underwriting and if we open up the question of charges 
 and countercharges, we shall inevitably have “under- 
 writing result” and “investment result” hopelessly in- 
 volved and confused, and both phrases stripped of their 
 plain and proper meanings. 
 
 Following is a graphic illustration of the relations 
 between the imderwriting and investment departments 
 of the business, based upon the actual experience of the 
 company in question for the year 1917, so that the 
 figures are not representing a hypothetical case, manu- 
 factured for the sake of producing a pre-determined 
 result, but are the conclusions drawn from the actual 
 transactions of the year indicated, showing that if we 
 embark on the policy of making charges and counter- 
 charges between the underwriting and investment de- 
 partments, we shall find the underwriting department 
 to be chargeable with very considerable amoimts not 
 now charged them, which presumably, as in this case, 
 ivill exceed the amount of credits which the proponents 
 
 12 
 
of the plan to consider interest on the reserve would 
 assign to the underwriting department. 
 
 Net fire premiums were $10,869,735. The reserve 
 table shows annual business on the books $5,362,830. 
 As all annual business in force at the end of the year 
 must have been written during the year, and as botli the 
 total net premiums and the annual premiums are ex- 
 pressed with reinsurance and cancellations out, it seems 
 proper to deduct the annual from the total to determine 
 the term business, which by this process, is found to be 
 $5,506,905. As the proportion between three-year and 
 five-year business outstanding written during the year is 
 about .685 for three-year and .315 for five-year busi- 
 ness, we divided the term premiums above indicated in 
 these proportions which produced $3,772,230 three-year 
 premiums, and $1,734,675 five-year premiums. The re- 
 sult is as follows: 
 
 Premiums Reserve 
 
 Annual premiums ... .$5,362,830 50% $2,681,415 
 
 Three years 3,772,230 83 1/3% 3,143,524 
 
 Five years 1,734,675 90% 1,561,208 
 
 Total $10,869,735 $7,386,147 
 
 The actual experience of the company referred to 
 for that year is that incurred underwriting expenses 
 were 38 5/10% of the premimns written. 
 
 Losses are not readily divisible between those oc- 
 curring under policies written in 1917 and those under 
 policies previously written, so that an estimate is neces- 
 sary in allowing for losses on the business of the current 
 year, but experience of companies, so far as available, 
 would indicate that 25% is a conservative allowance for 
 losses during the first year. 
 
 Reserve as indicated above results in a percentage of 
 about 67 9/10 for the fire business. 
 
 The result follows, indicating how the actual gain 
 from underwriting of $268,226 per the annual statement 
 
 Analysis of 
 Premiums for 
 Reserve. 
 
 Expenses. 
 
 Losses on 
 
 Current 
 
 Business, 
 
 13 
 
Deficit on 
 Current Busi- 
 ness Made Up 
 From Business 
 Previously on 
 Books. 
 
 is divided between accretions from business previously 
 on the books due to the earnings for the year of the 
 premiums on such business, less the losses ($3,619,488), 
 as against impairment, resulting from the current year’s 
 business put on the hooks subject to expenses,, losses and 
 a charge for reserve as indicated above ($3,351,262). 
 
 Current Business 
 
 Business Previously 
 on Books 
 
 Total 
 
 Income 
 
 Outgo 
 
 Income 
 
 Outgo 
 
 Income 
 
 Outgo 
 
 Net Premiums $11 399,603 
 
 
 
 
 $11,399,603 
 
 
 Losses incurred 25% 
 
 $2,849,901 
 
 
 $2,737,635 
 
 
 $5,587,536 
 
 Expenses incurred 
 (38.5%) 
 
 4,391,357 
 
 
 
 
 4,391,357 
 
 Reserve 67.9% of 
 fire business) 
 
 plus marine re- 
 serve 
 
 7,508,764 
 
 $6,357,123 
 
 
 
 1,151,641 
 
 Misc. items 
 
 843 
 
 
 
 
 843 
 
 $11,399,603 
 
 $14,750,865 
 
 $6,357,123 
 
 $2,737,635 
 
 $11,399 603 
 
 $11,131,377 
 
 
 11,399,603 
 
 2,737 635 
 
 
 11,131,377 
 
 
 Impairment, re- 
 sulting from cur- 
 rent business 
 
 Net accretion re- 
 sulting from bus- 
 iness previously 
 on the books 
 
 Gain from under- 
 writing per state- 
 ment 
 
 $3,351,262 
 
 $3 619,488 
 
 $268,226 
 
 PROOF 
 
 Net accretions from business previously on the books $3,619,488 
 
 Impairment resulting from current year’s business put on the books - 3,351,262 
 
 Gain from underwriting, per statement $ 268,226 
 
 Impairment 
 
 Repeated 
 
 Annually. 
 
 ( 1 ) Each year the new business put on the books will 
 produce a new impairment, which will be made up, 
 under favorable conditions, from the net accretions from 
 previous year’s business. But these accretions belonu 
 to the company by right of earning, irrespective ot 
 whether new business is done or not. Hence, it must 
 
 \ 
 
 14 
 
be recognized that in order to put the new business on 
 its books the company has to advance from the funds 
 which would otherwise be a part of the surplus the sum 
 of $3,351,262 and to advance a like sum each year. 
 
 Underwriting operations are indebted to capital 
 elements for the use of $3,351,262 (or a like sum), con- 
 tinuously, year by year. 
 
 (2) The charges for commissions and other charges 
 in agents’ and general agents’ accounts vary consider- 
 ably. General agency accounts contain charges of wide 
 diversity of character and amount. Assuming such 
 charges deducted before the accounts reach the company 
 average 30^ of the net premiums it follows that agents’ 
 balances equal 70^ of the net premiums. Agents’ bal- 
 ances created incidental to the placing on the books of 
 $11,399,603 net premiums would thus be $7,979,722, and 
 as the average term of credit is fully sixty days, equals 
 an average of $1,329,953 of the gross assets continuously 
 at the service of underwriting operations, without inter- 
 est. Hence, underwriting operations are indebted to 
 capital elements for the use of $1,329,953 (or a like sum), 
 year by year. 
 
 (3) If underwriting operations are to be credited 
 with income from investments comprising the reserve, 
 they must be charged with losses on sale or maturity of 
 assets in that proportion which the reserve bears to the 
 gross assets, as follows: 
 
 Loss on sale or maturity of ledger assets $77,639 
 
 Gain on sale or maturity of ledger assets 5,329 
 
 Net loss on sale or maturity of ledger assets $72,310 
 
 Gross assets $19,794,891 
 
 Reserve 10,979,583 
 
 Proportion 554 
 
 Proportion of net loss chargeable to reserve $40,059 
 
 Underwriting 
 Operations 
 Chargeable with 
 Amount of 
 Impairment. 
 
 Underwriting 
 Operations 
 Chargeable with 
 Loss of Interest 
 from Idle 
 Capital. 
 
 Underwriting 
 Operations 
 Chargeable with 
 Losses on 
 Investments. 
 
 15 
 
Underwriting 
 Operations 
 Chargeable with 
 Depreciation, 
 
 Underwriting 
 Operations 
 Chargeable with 
 Loss of Interest 
 From Semi-Idle 
 Capital, 
 
 Removal of an 
 
 Unwarranted 
 
 Credit 
 
 Now Made to 
 Underwriting 
 Operations. 
 
 (4) By the same reasoning underwriting operations 
 must be charged with the loss in surplus due to the de- 
 cline in market values, which for the company in ques- 
 
 tion in 1917, is as follows: 
 
 Decline in market values $324,529 
 
 Proportion (.554) chargeable to reserve 179,789 
 
 (5) The necessity under which insurance companies 
 are placed to maintain available cash in large sums re- 
 lates primarily to the steady volume of losses which must 
 be met and paid and the possibility of extraordinary 
 losses, the means for payment of which must be readily 
 at hand. During the year in question the company re- 
 ferred to kept average deposits in banks of about 
 $2,000,000, the earning capacity of which, if invested in 
 permanent investments, would have been about 5^, 
 but which, owing to the character of the business, and 
 the necessity for keeping this sum on hand, actually 
 earned less than 2%, resulting in a loss of over 3% di- 
 rectly chargeable to requirements incidental to imder- 
 writing. Estimated loss in interest, chargeable to under- 
 writing — $60,000. 
 
 (6) Under the convention form statement there is 
 an arbitrary charge to investment expenses of 1/8 of 1^ 
 oh the mean invented assets which represents no 
 actual outlay, but evidently what the brokers’ com- 
 mission would be if the whole amount of the mean 
 invested assets were reinvested during the year. The 
 only way this can be used as a charge against invest- 
 ments is to credit it to underwriting, and that is what 
 is done, but underwriting is not entitled to this credit, 
 because the charge is purely theoretical and arbitrary, 
 and not the result of actual transactions. This transfer 
 item for the company referred to, in 1917, was $17,831. 
 
 16 
 
If charges and countercharges are to be made, the 
 result will be as follows, assuming underwriting to be 
 credited with 5% on the average amount of reserve: 
 
 Debit Credit 
 
 Reserve at beginning of year, $9,827,- 
 942; end of year, $10,979,583; total, 
 
 $20,807,525. Average $10,403,762. 
 
 Allowance on average reserve at 5% $520,188 
 
 Item 1. Impairment from new busi- 
 ness. Use of $3,351,262 at 5% . . . $167,563 
 Item 2. Funds tied up in agents’ bal- 
 ances; Use of $7,979,722 at average 
 
 of 60 days equals $1,329,953 for one 
 
 year at 5% 66,497 
 
 Item 3. Proportion chargeable to re- 
 serve from loss on assets sales 40,059 
 
 Item 4. Proportion chargeable to re- 
 
 serve for decline in market values. . 179,789 
 Item 5. Loss of interest due to under- 
 writing requirements for holding 
 large sums available for losses. . . . 60,000 
 
 Item 6. Restoration to underwriting 
 expenses of the amount arbitrarily 
 removed therefrom as a charge to 
 investment expenses hy the re- 
 quirements of the convention form 
 statement, namely 1/8 of 1% of 
 mean invested assets, about 17,000 
 
 $530,908 $520,188 
 
 From the foregoing it will he seen that the possible 
 charges to underwriting exceed the possible credits to 
 underwriting in case the question of accounting between 
 the two is opened up and charges and credits are to be 
 made. 
 
 Developing somewhat further the conclusions ar- 
 rived at in the foregoing, the substitution of the average 
 
 Assumption of 
 Prevailing 
 Interest Rate 
 at 5%. 
 
 Result of 
 Offsetting 
 Charges and 
 Credits. 
 
 17 
 
Assumption of 
 Prevailing 
 Interest rate 
 of .0417. 
 
 Result of 
 Offsetting 
 Charges and 
 Credits. 
 
 rate of investment income earned on investments for 
 the arbitrary rate of 5%, produces the following pos- 
 sibly more nearly correct results. 
 
 This method differs from the previous method only 
 in that instead of assuming an average interest rate of 
 5% we have taken the actual income in its relation to 
 income producing assets, and obtained an average rate, 
 which is .0417. 
 
 Debit Credit 
 
 Reserve at beginning of year, $9,827,- 
 942; end of year, $10,979,583; total, 
 
 $20,807,525. Average $10,403,762. 
 
 Allowance on average reserve at 
 
 .0417 $433,836 
 
 Item 1. Impairment from new busi- 
 ness. Use of $3,351,262 at .0417. .$139,747 
 
 Item 2. Funds tied up in agents’ bal- 
 ances; Use of $7,979,722 at average 
 of 60 days equals $1,329,953 for one 
 
 year at .0417 55,459 
 
 Item 3. Proportion chargeable to re- 
 serve from loss on assets sales 40,059 
 
 Item 4. Proportion chargeable to re- 
 
 serve for decline in market values. . 179,789 
 Item 5. Loss of interest due to under- 
 writing requirements for holding 
 large sums available for losses. . . . 43,400 
 
 Item 6. Restoration to underwriting 
 expenses of the amount arbitrarily 
 removed therefrom as charge to in- 
 vestment expenses by the require- 
 ments of the convention form state- 
 ment, namely ^ of 1% of mean in- 
 vested assets, about 17,000 
 
 $475,454 $433,836 
 By this method, underwriting is to be charged with 
 $41,618 more than the credit amounts to. 
 
 18 
 
The foregoing demonstrates that, both in theory and Conclusions. 
 in practice, each new year’s business put on the books 
 of any company, however old and well established, 
 creates an impairment, precisely as it does in the case 
 of any new company just starting in business, also that 
 there are a number of conditions, penalties and handi- 
 caps under which the investment department of the 
 business is placed for the benefit of underwriting opera- 
 tions, which, if there is to be an accounting between the 
 two departments, will have to be charged against under- 
 writing. Furthermore, that whenever interest and divi- 
 dend elements are taken out of investment income and 
 treated as underwriting, a confusion in terms ensues by 
 which the terms ‘‘underwriting income” and “investment 
 income” become hopelessly confused and each robbed 
 of its proper meaning. 
 
 FOURTH 
 
 DEFINE WHAT IS TO CONSTITUTE A CONFLA- 
 ORATION AND DETERMINE WHAT PART OF 
 THE CONFLAGRATION WOULD BE PROPERLY 
 CHARGEABLE TO THE STATE IN WHICH THE 
 FIRE OCCURS. 
 
 A conflagration may be regarded as any casualty Definition of 
 which produces a loss of a million dollars or more, and Conflagration. 
 since underwriting profit as ordinarily computed based 
 upon ordinary losses makes no allowance for the extra 
 demands upon the companies for unusual and abnormal 
 items of conflagration losses, an additional margin of 
 underwriting profit should be allowed the companies 
 annually to absorb such extraordinary losses as they 
 occur. 
 
 The total fire and tornado premiums of stock com- 
 panies, Mutuals and Lloyds, in the United States and 
 Canada for the year 1917 are reported as $486,650,720. 
 
 If we regard individual losses exceeding $1,000,000 as 
 
 19 
 
Minimum 
 Allowance for 
 Conflagration 
 Reserve. 
 
 Conflagrations 
 Chargeable to 
 Operations Over 
 Entire 
 Country, 
 
 conflagrations, such losses constituted over 11% of the 
 net premiums, but, of course, the figures quoted are the 
 property loss, and not the losses covered by insurance. 
 On the other hand, they do not include hail and tornado 
 losses. Insurance is yearly becoming more universal. 
 If only one-half of the property destroyed in the large 
 losses in the future is covered by insurance, and such 
 losses continue at the average of the last thirteen years, 
 the conflagration losses, using the above definition for 
 illustration, would be over 5^% of the net premiums, 
 and this is on fire loss alone, not taking into account hail 
 and tornado. We, therefore, suggest 5% as a very con- 
 servative minimum reserve against conflagration. Great 
 conflagrations cannot be charged to the state in which 
 they occur, for the purpose of making rates in that state 
 to produce an underwriting profit. The San Francisco 
 loss resulted in property damage of $350,000,000, which 
 it would be hopeless to expect the State of California 
 to pay by an increase in the insurance rates. Such losses 
 must be paid for by the premiums of the entire country, 
 and if proper allowance is made in each state for the 
 conflagration hazard, both within and without the state, 
 from the premiums earned in each such state (and a 
 reasonable underwriting profit provided after such de- 
 duction), this will be done. 
 
 FIFTH 
 
 TO OUTLINE A PLAN COMPLETE AS TO DETAIL, 
 BY WHICH THE VARIOUS STATES CAN BE 
 GUIDED UNIFORMLY IN MAKING THEIR ESTI- 
 MATES. 
 
 Principles, The following plan is based upon the principles laid 
 
 down in the Convention Blank for determining under- 
 writing profit, which we believe to be correct; 
 
 I. PREMIUMS. 
 
 I. Gross premiums on risks written, less return p re- 
 
 20 
 
miums and premiums for all reinsurances, whether in 
 authorized or unauthorized companies, on property in 
 the state during the year as reported in the annual 
 statements after allowing for adjustment, if any, to 
 include all reinsurances as defined above. 
 
 2. Add unearned premiums on outstanding business 
 in the state at the end of the preceding year. 
 
 3. Deduct unearned premimns on outstanding busi- 
 ness in the state at the end of the year under considera- 
 tion. 
 
 4. Result: Premiums earned during the year under 
 consideration. 
 
 Note: If companies do not carry their premium 
 
 reserve separately by states, the unearned premiums 
 should he estimated as follows: 
 
 (a) Unearned premiums of whole company as 
 of the date desired as shown on Page 5 of annual 
 statements. 
 
 (b) Net premiums written by the company dur- 
 ing the year ending on the date desired as shown 
 on Page 2 of annual statements. 
 
 (c) Net premiums written in the state for the 
 period used in (b) computed in the manner set 
 forth in Item 1 above. 
 
 (d) Compute the ratio of (c) to (b). 
 
 (e) Apply the ratio made by method (d) to the 
 unearned premiums of whole company (see a). 
 
 Result: Estimated unearned premiums for the state 
 under consideration to be used under Item 2 or Item 3, 
 above, as the case may be. 
 
 II. LOSSES. 
 
 Losses incurred in the state, less amounts recovered or 
 recoverable on risks reinsured, whether in authorized or 
 unauthorized companies, as shown in the exhibit of 
 state business in the Annual Statement after allowing 
 for adjustment, if any, to include all reinsurances as set 
 forth above. 
 
 Earned 
 
 Premiums. 
 
 Formula. 
 
 Incurred 
 
 Losses. 
 
 21 
 
m. EXPENSES. 
 
 Direct 
 
 Expense. 
 
 Primary 
 
 Overhead. 
 
 1. Specific Expenses. All agency commissions and 
 other agency expenses, taxes, licenses, fees, assessments, 
 membership in rating bureaux or underwriters’ associa- 
 tions, if any, operating in compliance with or permitted 
 by law, advertising required by law, special agents’ 
 salaries and expenses, loss adjustment expenses, expenses 
 for litigation or legal advice, maps, inspections, surveys 
 and other expenses incurred and paid directly and speci- 
 fically for the purpose of doing business in the state 
 under consideration. 
 
 2. General Expenses. That proportion of general or 
 overhead expenses such as salaries of officers and home 
 office employees, printing and stationery, federal gov- 
 ernment taxes, postage, telegrams, telephone and ex- 
 press, mercantile reports, advertising, home office main- 
 tenance expenses including light, heat, janitor service, 
 etc., furniture and fixtures, books of account, and other 
 expenses not chargeable to the business in any particular 
 state, which the net premiums received from business 
 in the state under consideration hear to all net pre- 
 miums received by the company for the current year. 
 
 Adjustment to 
 
 Incurred 
 
 Basis. 
 
 3. Incurred Expenses. In order to put Item 2 on an 
 incurred basis, there should be included therein not only 
 expenses of the character enumerated and described 
 when actually paid, but also those, liability for which 
 has been incurred and is capable of determination or 
 estimate at the time of making up the annual statement. 
 Hence, the items on Page 5 of the Annual Statement, 
 representing, respectively, “Salaries, rents, expenses, 
 bills, accounts, fees, etc., due or accrued,” — “Estimated 
 amount hereafter payable for federal, state and other 
 taxes based upon the business of the year of this state- 
 ment,” and “contingent commissions or other charges 
 due or accrued” should be taken into consideration, and 
 on the increase or decrease in such items during the 
 year a like proportion to that provided in Item 2 for 
 general expenses paid should be figured, and the result 
 
 22 
 
should be used to increase the expenses if the above 
 reserves showed an increase, or to reduce the expenses 
 if they showed a decrease. 
 
 4. Departmental Expenses. If the business in the 
 state under consideration, or any part thereof, is oper- 
 ated through a departmental office, or is subject to ex- 
 penses incurred in common with the business in some 
 other state or group of states, and not separated and 
 specifically charged to the results of each individual 
 state, such secondary overhead expenses should be dis- 
 tributed among the states for which they were incurred 
 by a like process to that employed for the distribution 
 of general expenses or primary overhead expenses, as 
 outlined in paragraph 2; the only difference being that 
 in this case the distribution is confined to the results 
 of the limited number of states involved, in the propor- 
 tion that the premiums received on business in each, 
 bears to the sum of the premiums received on business 
 in all of them. 
 
 IV. ALLOWANCE FOR CONFLAGRATION HAZARD. 
 
 No formula for computing underwriting profit or 
 loss is correct which does not allow for the unusual and 
 extraordinary losses commonly called conflagrations, but 
 which should include large, general and sweeping losses 
 by hail and tornado as well as by fire. Recently enacted 
 laws clearly recognize this principle. For example — 
 that enacted in Colorado in the Legislative Session 
 of 1919, provides as follows: “In determining the ques- 
 tion of a reasonable underwriting profit, the Commis- 
 sioner of Insurance, as a protection to policyholders, 
 shall give proper and reasonable consideration to the 
 conflagration liability within and without the state.” 
 
 V. UNDERWRITING PROFIT. 
 
 The remainder of net premiums earned (I), after 
 deducting losses (II), expenses (III) and allowance for 
 conflagration hazard (IV), will be the underwriting 
 
 Secondary 
 
 Overhead. 
 
 Necessity for 
 Consideration 
 
 Precedents. 
 
 Derivation. 
 
 23 
 
Formula. 
 
 profit — ^which the answer to question “First” specifies 
 should equal 5^ of the net premiums earned, viz.: 
 
 Earned Premiums (Net) 
 
 Incurred Losses (Net) 
 
 Expenses Incurred: 
 
 Specific 
 
 General 
 
 Departmental 
 
 Total Expenses 
 
 Allowance for Con- 
 flagration Hazard 
 
 Underwriting profit or loss 
 
 ‘■iii 
 
 I 
 
 24 
 
APPENDIX DEFINING THE LEGAL STATUS OF 
 THE UNEARNED PREMIUM RESERVE OF 
 STOCK FIRE INSURANCE COMPANIES 
 
 The courts in the various states have many times 
 been called upon to determine the legal status of this 
 reserve, and have uniformly held that 
 
 First: It is the exclusive property of the company 
 
 and not such as is held in trust for the benefit of its 
 policyholders ; 
 
 Second: The right of the insured to recover a part 
 
 of his premium is a mere incident of the contract not 
 contemplated by either party at the inception of the 
 contract ; 
 
 Third: The right to recover is so remote as not to 
 
 be worthy of consideration in determining the surplus 
 of the company; 
 
 Fourth: A statutory provision that the so-called un- 
 
 earned premium reserve is to be treated as a liability 
 by the company, and an insurance commissioner for 
 the purpose of bookkeeping and a financial report does 
 not change its character from an asset of the company 
 to a liability. 
 
 In order to determine the status of the reserve it is 
 necessary to determine if it is property, and, if so, to 
 whom such property belongs. Of course, as it is money 
 or its equivalent, it is property. It is paid over by the 
 assured to the company and treated by him as an item 
 of expense. He has lessened the value of his assets by 
 that sum. The assets of the company have been in- 
 creased in the same manner. The company may use 
 it in the payment of any claim or indebtedness of any 
 kind which it may have, or may use it in the transaction 
 or furtherance of its business in any manner, and the 
 proceeds thereof inure solely to the benefit of the 
 company. 
 
 Summary of 
 Decisions. 
 
 Nature and 
 Origin of 
 Reserve. 
 
 25 
 
In the case of the People’s Fire Insurance Co. vs. 
 Parker, 34 N. J. L. 479, the Supreme Court says: 
 
 Effect of 
 Liability by 
 Contingency of 
 Loss. 
 
 “It is liable to the contingency of loss upon the 
 policies issued, hut it is as much the property of 
 the company and as fully under its control as the 
 capital stock paid in. It is asserted that the com- 
 pany does not actually own these premiums because 
 they are subject to the risks taken until the policies 
 expire by limitation, and that this constitutes a 
 liability in the nature of an indebtedness against 
 the company. This consideration cannot affect the 
 character of the fund as an accumulated surplus. 
 The liability is contingent; it may or may not ac- 
 tually attach, and, if it does, it will reach to and 
 affect the capital stock and such premiums as have 
 been received on expired risks as fully as those re- 
 ceived on unexpired risks.” 
 
 The Court of Errors and Appeals of New Jersey 
 affirmed the judgment of the Supreme Court, and in 
 passing upon the question holds: 
 
 Effect of 
 Provision for 
 Return of 
 Premium Upon 
 Cancellation, 
 
 “The usual stipulation that in the event of a 
 transfer of the property insured and the termina- 
 tion of the insurer’s risk a part of the premium may 
 be reclaimed, proportionate to the time the risk 
 has to run is hut a contingency and not such a 
 charge upon the premium that it takes away the 
 right of property and ownership. Such liability 
 to return is in the same class as possible losses by 
 fire, against which provision is made by the capital 
 stock and the reserve fund of the corporation, which 
 is called accumulated surplus. It is not a specific 
 charge on the premium paid, hut a possible liability 
 that may be claimed out of the general assets of the 
 company.” (People’s Fire Insurance Co. vs. Parker, 
 35 N. J. L. 575.) 
 
 In the case of Kenton Insurance Company vs. City 
 of Covington, 86 Ky. 213, the court holds the unearned 
 
 26 
 
premium reserve is the property of the company, and 
 says: 
 
 “The Act of March 12, 1870, with reference to 
 the payment of dividends, requiring that no divi- 
 dends shall he made of this reserve fund, does not 
 divest this corporation of its right of property in 
 it ; or to use and invest it for the benefit of its stock- 
 holders*' 
 
 The most recent case touching on property rights 
 is the case of the Oklahoma National Life Insurance 
 Company, 173 Pac. 376, in which the court expresses 
 its opinion as follows: 
 
 “We therefore conclude that the portion of the 
 assets of the corporation which represents the re- 
 serve is as much the property of the corporation as 
 that portion which represents the contributions of 
 the stockholders or funds derived from other 
 sources.” 
 
 In the case of the Westchester Fire Insurance Co. vs. 
 Davenport, 91 N. Y. 575, the court says: 
 
 “To say that such receipts constitute a trust 
 fund held by an insurance company for the use of 
 the policyholders or that it is a liability of the 
 company in any such sense * * * is contrary to 
 reason and is not sustained by any authority known 
 to us. The insurer in fact not only acquires the 
 absolute ownership of such moneys when received 
 for premiums, but is by the lapse of time soon freed 
 from liability to repay any part thereof to the 
 policyholders except in those occasional instances 
 where the loss occurs.” 
 
 Referring to the opinion in the case of the Detroit 
 F. & M. Insurance Co. vs. Hartz, 132 Mich. 518, decided 
 March 7, 1903, in which the court, in passing upon the 
 proposition that the fund was a liability because, first, 
 it is treated as a liability by the company and the in- 
 surance commissioner for the purpose of bookkeeping 
 
 Effect of 
 Legislation as to 
 Payment of 
 Dividends. 
 
 Comparison of 
 With Other 
 Capital 
 Elements. 
 
 Negation of 
 
 Trust 
 
 Relation. 
 
 Irrelevancy of 
 Statement and 
 Accounting 
 Treatment as 
 Determining 
 Ownership. 
 
 27 
 
Further 
 
 Decisions. 
 
 Summary of 
 Decisions. 
 
 and a financial report, and, second, for the reason that 
 the policies of the company are subject to cancellation 
 and an unearned premium may in that event be de- 
 manded by the insured, said: 
 
 “Neither of these justifies such an assertion. 
 The fund called ‘reserve fund’ is the property of 
 the company. For the purpose of protection to 
 patrons of the company, the law requires it to be 
 kept in a fund called a ‘reinsurance reserve fund’ 
 so that the company may have the means to re- 
 insure its risks if necessary, which it is given power 
 to do; hut its character is not changed on that 
 account.” 
 
 The same line of reasoning is uniformly followed 
 in other cases decided by the courts. For additional 
 decisions see People ex rel Manhattan Fire Insurance 
 Company, 76 N. Y. 64; Home Fire Insurance Company 
 vs. Lynch, 19 Utah 189; Insurance Company vs. Cap- 
 pellar, 38 Ohio State, 560; City of Yale vs. Michigan 
 Farmers’ Mutual Insurance Co., 179 Mich. 254; Trenton 
 vs. Standard Fire Insurance Company, 77 N. J. L. 656. 
 
 It is evident from the above that the courts uniformly 
 and properly held that the unearned premium reserve 
 is the property of the corporation. It is further evi- 
 denced by the fact that the requirement of the various 
 states does not deprive a claimant of his right to attach 
 such moneys nor prohibit a company from using same 
 to meet any of its obligations other than the payment 
 of dividends. It is as available for the payments of 
 any claim as the moneys paid in for capital stock or 
 derived from any other sources. By every test this re- 
 serve is as truly the property of the company as the 
 surplus paid in by the stockholders, and there is no 
 more obligation on the part of the company to meet 
 its claims from this reserve than there is from its paid- 
 in surplus or capital. Its ownership in the company 
 is as entire and complete as the ownership in any other 
 of its assets. 
 
 28 
 
In the case of impairment by reason of insufficient 
 assets, the policyholder derives no greater benefit, nor 
 has any special privilege over any other claimant in 
 the distribution of the reserve. It is true, the policy- 
 holder would have a right to enforce a claim against the 
 receiver if he had a claim arising under a policy con- 
 tract, but he would be on the same plane as any other 
 creditor in the distribution of the assets of the company, 
 including this so-called reserve. 
 
 In the interest of brevity we have not attempted to 
 cite all of the decisions nor present more than enough, 
 we think, to satisfy the most skeptical that the unearned 
 premium reserve is the property of the company and 
 is invested for the benefit of the stockholders, for, as 
 held in the case of Kenton Insurance Company vs. City 
 of Covington (above cited), an act with reference to 
 the payment of dividends requiring that no dividends 
 shall he made of this reserve does not divest the cor- 
 poration of its right of property in it, or to use it and 
 invest it for the benefit of its stockholders. 
 
 Creditors* 
 
 Claims. 
 
 Conclusion. 
 
 29 
 

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