RiskBased Capital for Insurers: The U' S' System

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

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Historical Development

• RBC Formulas Developed During 1990s
• Life Formula Introduced In 1993
• PC 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

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THE NAIC RBC System

• Risk-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

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Purpose of Regulatory Capital

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

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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 Insurers Own Internal
  Capital Standards And From Standards Set By
  Private Rating Agencies

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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

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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

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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

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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)

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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
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Life Industry Aggregate RBC By Size
Source NAIC Research Quarterly April 1997, page
37
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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

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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

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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 insurers business and operations deemed
necessary. The state insurance commissioner
issues appropriate corrective orders to address
the companys financial problems.
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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.

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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

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Capital-to-Assets and RBC-to-Assets By Size Groups
Life Companies
Life Companies
Source NAIC Research Quarterly April 1995
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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.
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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

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Conclusions Regarding NAICs 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