by John Darer CLU ChFC MSSC RSP CLTC
Risk Based Capital is an important regulatory tool designed to maintain solvency of insurance companies.
What is Risk Based Capital?
Risk-based capital is a method developed by the National Association of Insurance Commissioners ( NAIC) to measure the minimum amount of capital that an insurance company needs to support its overall business operations. Risk-based capital is used to set capital requirements considering the size and degree of risk taken by the insurer. For example, it requires a company with a higher amount of risk to hold a higher amount of capital. Capital provides a cushion to a company against insolvency. Currently there are four major categories of risk that must be measured to arrive at an overall risk-based capital amount. These categories are:
- Asset Risk- a measure of an asset's default of principal or interest or fluctuation in market value as a result of changes in the market.
- Credit Risk- a measure of the default risk on amounts that are due from policyholders, reinsurers or creditors.
- Underwriting Risk- a measure of the risk that arises from under-estimating the liabilities from business already written or inadequately pricing current or prospective business.
- Off-Balance Sheet Risk- a measure of risk due to excessive rates of growth, contingent liabilities or other items not reflected on the balance sheet..
RBC formula requirements can be higher or lower than the fixed state minimum capital requirements (which are typically $1 to $2 million), but each insurance company must meet both sets of standards. For virtually all medium to larger insurers, the capital requirements generated by the RBC formula are higher than the state fixed capital standards.
What Are The Origins of Risk Based Capital Standard?
The NAIC’s Risk Based Capital Standard for life insurance companies was established in 1993 as an early warning system for U.S. insurance regulators [separate RBC for P&C in 1994 and health insurers in 1998]. The adoption of the U.S. RBC standard was driven by a string of insurer insolvencies that occurred in late 1980s and early 1990s, such as Baldwin United, Charter and Executive Life and ELNY. The NAIC established a working group to look at the feasibility of developing a statutory risk-based capital requirement for insurers. The RBC regime was created to provide a capital adequacy standard that is related to risk, raises a safety net for insurers, is uniform among the states, and provides regulatory authority for timely action. It has two main components:
- The risk-based capital formula, that established a hypothetical minimum capital level that is compared to a company’s actual capital level, and
- A risk-based capital model law that grants automatic authority to the state insurance regulator to take specific actions based on the level of impairment.
What Tools Does a Regulator Have Under the Risk Based Capital Standard?
Regulators have the authority and statutory mandate to take preventive and corrective measures that vary depending on the capital deficiency indicated by the Risk Based Capital result. These preventive and corrective measures are designed to provide for early regulatory intervention to correct problems before insolvencies become inevitable, thereby minimizing the number and adverse impact of insolvencies. The NAIC RBC formula generates the regulatory minimum amount of capital that a company is required to maintain to avoid regulatory action.
There are four levels of action that a company can trigger under the formula:
- Company action
- Regulatory action
- Authorized control
- Mandatory control levels.
Each Risk Based Capital level requires some particular action on the part of the regulator, the company, or both. For example, an insurer that breaches the Company Action Level must produce a plan to restore its Risk bsed Capital levels. This could include adding capital, purchasing reinsurance, reducing the amount of insurance it writes, or pursuing a merger or acquisition.
Risk Based Capital formulas are constantly under review for refinement,iImprovement in factors and updating for new risks and a changing environment.
- NAIC website
- NAIC White Paper The US National State Based System of Insurance Financial Regulation and the Solvency Modernization Initiative 2010 http://www.naic.org/documents/committees_e_us_solvency_framework.pdf
- Rick Based Capital For Insurers Model Act January 2012 http://www.naic.org/store/free/MDL-312.pdf
- Recommended Approach for Updating Regulatory Risk-Based Capital Requirements for Interest Rate Risk for Fixed Annuities and Single Premium Life Insurance June 2014, American Academy of Actuaries http://www.naic.org/documents/committees_e_capad_lrbc_aaa_c3pi_report_140611.pdf
Risk Based Capital for Insurers in the United States Illinois State University https://math.illinoisstate.edu/krzysio/MAT483/RBC.pdf