Risk-Based Capital for Insurers: The U. S. System

Presented at the World Bank’s Contractual Savings Conference, May 2002

Michael M. Barth, Ph.D. Assistant Professor of Finance

Department of Finance & Economics Georgia Southern University

Statesboro, GA 30460 (912) 681-0259

mbarth@gasou.edu

National Association of Insurance Commissioners (NAIC)

Association of chief regulators in 50 states, District of Columbia, American Samoa, Guam, Puerto Rico and U.S. Virgin Islands

Established in 1875 to enhance coordination between states

Maintains common database

Has no authority in and of itself – regulatory powers reside with members

Historical Development• RBC Formulas Developed During 1990s

• Life Formula Introduced In 1993• P&C Formula Introduced in 1994• Health Organizations Formula Introduced in 1998

• Same Time Frame Saw a Variety of Initiatives Including FAST, Accreditation, Accounting Changes

• Significant Input From Industry On Design Of Formula And Formula Components

• American Academy of Actuaries• Interested Parties• Regulators• NAIC Staff

• RBC Is Only One Component In Regulatory Toolbox

THE NAIC RBC SystemRisk-Based Capital Formulas

Life Insurer Version

Property/Casualty Version

Health Organizations Version

Fraternal Version

Risk-Based Capital for Insurers Model Act Serves As A Guide for State Laws

Risk-Based Capital Law In Each State Makes System Operational

NAIC Produces Common Formula By Agreement But Regulatory Powers Reside With States

RBC Is Meant To Streamline Regulatory Process, Not To Introduce New Regulatory Powers

Purpose of Regulatory Capital

• To ensure that the insurer does not use excessive financial leverage

• To reasonably guaranty that the insurer’s promises are met

• To allow timely intervention in case of financial distress

• To conserve the remaining assets in the wake of financial distress to an insurer

• To avoid unreasonable interference with the financial decisions and management of the insurer

Other Capital Standards• Significant Developments in Tandem with

NAIC RBC

• Regulatory Purpose is to Establish Minimum Standards while Rating Agency Purpose is to Establish Qualitative Standards

• Regulatory Capital Standards Can And Do Differ Significantly From An Insurer’s Own Internal Capital Standards And From Standards Set By Private Rating Agencies

Minimum Capital Standards• Vary From State to State

• Generally Range From $1 Million to $2 Million

• Multi-line Requirements Are Usually Less Than Aggregate Monoline Requirements

• Can Include "Experience" Factor for Longevity

• In Some States, a Variable Minimum Standard Is Applied With Some Recognition of Risk

• Minimum Is Material to Most Companies Because of Size But Immaterial to Large Companies That Make Up Bulk of Industry Volume

• RBC System Is a Complement to State Minimums

Regulatory Minimum RBC

Regulatory minimum RBC standards are set at minimum levels so as to impose a floor level of safety on the operations of an insurance company

System allows companies freedom to operate as long as capital exceeds the regulatory minimum

Minimizes market disruptions by non-managers while still maintaining minimum safety levels

Regulatory minimum standard makes comparisons between companies inappropriate

Regulatory minimum is NOT “best” capital amount

Problems With Common Standards

• "One Size Fits All" Approach Must Be Applied Uniformly To All Companies

• Reliance On Accounting Values• Not All Risks Accounted For

•Simplicity Tradeoffs•Measurement Errors•Political Considerations

• Each Component is Material to Someone• Regulatory Approaches Differ• Concerns About State Sovereignty

Basic NAIC Formula Computation

• Apply risk factors against annual statement values (factor approach) or use proprietary data (internal review approach)

• Sum risk amounts and adjust for statistical independence

• Calculate Authorized Control Level Risk-Based Capital (ACL RBC) amount, which is the amount of capital necessary to avoid automatic regulatory intervention

• Compare ACL RBC to Total Adjusted Capital (TAC)

Major Categories of Risk in the Life Formula

C0 – Affiliates Risk

C1cs -- Asset Risk – Unaffiliated Common Stock

C1o – Asset Risk – Other Assets

C2 – Insurance Risk

C3a – Interest Rate Risk

C3b – Health Credit Risk

C4a – General Business Risk

C4b – Administrative Expense Risk

Life Industry Aggregate RBC By Size

Source: NAIC Research Quarterly April 1997, page 37

The RBC Ratio Determines the Action Level According To State Statute

NAIC RBC standard is a minimum standard that is GRADUATED so that regulators have freedom and discretion to deal with troubled insurers.

Definition of “financial impairment” is now codified

Total Adjusted Capital (Actual Capital) is divided by Authorized Control Level RBC (Hypothetical Minimum Capital) to get the RBC Ratio

•No Action (98% of companies) -- TAC/RBC over 200%•Company Action Level -- TAC/RBC is 150% to 200%•Authorized Control Level -- TAC/RBC is 70% to 100%•Mandatory Control Level -- TAC/RBC is less than 70%

Company Action Level

Insurer submits a comprehensive financial plan that:

• Identifies conditions that led to financial problems

• Contains proposals to correct financial problems

• Provides projections future financial conditions

• Lists key assumptions underlying the projections

• Identifies problems areas and quality areas of insurer's business

Insurer is expected to comply automatically with these provisions, or drop to the Regulatory Action Level

Regulatory Action Level

Insurer is required to file an action plan as required under the Company Action Level. In addition, the state insurance commissioner is required to perform any examinations or analyses of the insurer’s business and operations deemed necessary. The state insurance commissioner issues appropriate corrective orders to address the company’s financial problems.

Authorized Control Level

• This is the first point at which the state insurance commissioner is authorized by law to take control of the insurer – the first point at which the insurer is technically insolvent.

• This authorization is in addition to the remedies available at the higher action levels.

• The insurance company should still be have more assets than liabilities (capital greater than zero)

• Commissioner is authorized to take control, but not required to take control

• Maximizes Commissioner's discretion.

Mandatory Control Level

• State insurance regulator is required to take steps to place the insurer under regulatory control

• Requirement protects all policyholders by imposing an absolute limit on regulatory discretion

• Insurer may still be solvent, with assets greater than liabilities, but in many cases insurer is fully bankrupt

• All regulatory remedies under other action levels apply here as well

• Appeals process is included in Model Law to ensure due process

Capital-to-Assets and RBC-to-Assets By Size Groups

Source: NAIC Research Quarterly April 1995

Life CompaniesLife Companies

Assets Up to $10M

Assets $10M to

$50M

Assets $50M to $250M

Assets $250M to $1,000M

Assets Over $1B All

Number of Companies 218 262 197 182 207 1,066

Number w/CAL RBC less than $1 million 186 113 6 0 0 305Percent of Total 85.3% 43.1% 3.0% 0.0% 0.0% 28.6%

Number w/RBC Ratio less than 250% 7 10 3 1 0 21Percent of Total 3.2% 3.8% 1.5% 0.5% 0.0% 2.0%

1st Percentile RBC Ratio 158% 189% 232% 267% 275% 206%5th Percentile RBC Ratio 293% 257% 296% 333% 370% 302%25th Percentile RBC Ratio 1563% 605% 564% 528% 525% 568%

50th Percentile RBC Ratio 3718% 1360% 865% 790% 657% 915%75th Percentile RBC Ratio 18938% 3154% 1516% 1133% 830% 2106%95th Percentile RBC Ratio 393891% 21448% 4497% 2724% 1409% 28919%

Median Absolute Change in RBC Ratio, 2000-01 16.26 3.23 1.51 1.21 0.99 1.94

Table 1RBC Results Reported in Five-Year History, Calendar Year 2001 Data

Variations in Capital By Size

Smaller insurers have much greater variation in capital than larger insurers, which is why they already hold more capital. The degree to which capital can move is also a function of size. RBC is meant to establish a floor level of capital, not an average or optimal.

Percentile

Assets

Up to $10M

Assets

$10M to $50M

Assets

$50M to $250M

Assets

$250M to $1,000M

Assets Over $1B

Assets

Up to $10M

Assets

$10M to $50M

Assets

$50M to $250M

Assets

$250M to $1,000M

Assets Over $1B

1% 8.2% 4.8% 5.6% 4.4% 3.0% 0.0% 0.1% 0.9% 1.1% 0.9%5% 16.6% 9.6% 8.0% 5.8% 4.7% 0.1% 0.8% 1.7% 1.7% 1.6%

25% 51.2% 27.0% 15.9% 9.7% 7.5% 0.8% 2.5% 3.1% 2.3% 2.3%50% 79.7% 42.1% 27.8% 15.3% 10.3% 3.0% 5.2% 5.4% 3.4% 3.0%

75% 94.0% 66.9% 50.1% 26.1% 15.8% 7.1% 10.3% 9.9% 5.7% 4.3%95% 99.4% 97.5% 89.5% 79.8% 40.2% 34.8% 23.0% 24.3% 19.0% 12.0%

99% 100.0% 99.8% 110.0% 100.4% 73.1% 56.6% 38.6% 40.9% 39.4% 29.5%

Total Adjusted Capital to Assets Ratio CAL RBC to Assets Ratio

Table 2Comparisons of Capitalization Ratios For Life Insurers

Using 2001 Statement Year Data

Omissions From Regulatory RBC

• Not All Risks Are Accounted For In The Formula (e.g., Liquidity Risk)

• Measures Of Risk Are Continually Refined (e.g., Interest Rate Risk)

• Some Risk Measures Are Inappropriate For A Public, REGULATORY MINIMUM Formula Approach (e.g., Management Quality)

• Awareness Of Risks Included AND Excluded Is Primary Benefit Of On-Going Formula Development

Conclusions Regarding NAIC’s Regulatory Minimum RBC Formula• It is better than what existed before• It is part of A comprehensive toolbox• Most criticism of the NAIC RBC formula is based on

its inability to predict insolvency, but that is not how it is designed and is not the underlying purpose

• Complexity does not mean accuracy, but does enhance awareness

• Simplicity tradeoffs often produce an equal, if not better, measurement of risk in a regulatory formula

• Primary benefit has been increased awareness of risk by all parties as well as greater information sharing between industry players