U. S. Risk-Based Capital Requirements and Their Context

1
U. S. Risk-BasedCapital Requirements and Their
Context
Alfred W. Gross Virginia Commissioner of
Insurance National Association of Insurance
Commissioners October 11, 2002
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What is RBC?

• Basic formula compares reported capital to
  risk-based capital requirement
• Requirement calculated by applying factors to
  various asset, credit, reserve and off-balance
  sheet items
• taken from NAIC Financial Analysis Handbook
  Property/Casualty Edition, 2001 Annual

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What is RBC? (continued)

• Factor is higher for those items with greater
  underlying risk
• Risk-based capital ratio is defined as a ratio of
  actual capital (i.e. total adjusted capital)
  divided by required capital (i.e. authorized
  control level risked based capital)
• Regulatory action taken on basis of this ratio

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Standard U. S. Regulatory FilingsFinancial
Reporting

• Annual Statements
• Quarterly Statements
• Management Discussion and Analysis
• Actuarial Opinion
• Annual Audited Financial Statements
• Risk-Based Capital Report

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Standardized Risk-BasedCapital (RBC) Report

• Uniform Approach Across Companies and U. S.
  Jurisdictions
• Based on U. S. Statutory Annual Statement Blank
  (A.S.)
• Values are taken from A.S. and have no meaning
  outside of A.S. context U. S. statutory
  accounting model
• Formulas and calibration of results are based
  aggregate industry statistics taken from A.S.
  reporting

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Standardized RBC Report (continued)

• Based on historical financial reporting, not
  forward looking
• Dependent on accounting definition of solvency
  (asset-liabilities)
• Works within the surplus geography of the A.S.,
  e.g., hidden margins in conservatively valued
  assets and technical provisions

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The RBC System

• Background
• 1993 Life
• 1994 Property/Casualty
• 1998 Health
• Designed to provide regulators with some degree
  of control in monitoring risks taken by insurers
• Designed to provide companies with some
  cost-benefit mindset in their asset allocation
  decisions

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The RBC System (continued)

• Tensions in Capital Regulation and Standards
• Desire to minimize free surplus so as to focus
  investment in underwriting business and to use
  financial leverage (e.g., debt) to provide
  greater returns (management perspective)
• VS.
• Need to hold a minimum amount as free surplus
  to ensure company performance (regulator
  perspective)

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The RBC System (continued)

• Need for a straight-forward, transparent, legally
  workable and fair approach across all companies
  in a competitive market
• VS.
• Need to be sensitive to individual company
  characteristics, e.g., types of risks, levels of
  exposure, and management capabilities

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The RBC System (continued)

• RBC is a Regulatory Tool
• Signaling mechanism between regulators and
  insurance companies as to poorly capitalized
  companies
• Act as a tripwire providing clear regulatory
  authority for intervention at defined action
  levels
• RBC is not
• A silver bullet to stop insolvencies
• A system for ranking or rating companies
• A precise diagnostic tool to define problematic
  companies

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RBC Formulas

• Life and Health
• Property and Casualty
• Health

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Life RBC - Components

• Insurance Affiliate Investment and Non-Derivative
  off-balance Sheet Risk (C0)
• Invested Asset Risk - Common Stock (C1cs)
• Invested Asset Risk - Other (C1o)
• Insurance Risk or Pricing Risk (C2)
• Interest Rate Risk (C3a)
• Health Provider Credit Risk (C3b)
• Business Risk - Guaranty Fund Assessment Risk
  (C4a)
• Business Risk - Health Administration Expense
  Risk (C4b)
• Covariance Adjustment

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RBC - Action LevelsTotal Adjusted
Capital/Authorized Control Level RBC

• No Action Level
• Company Action Level
• Regulatory Action Level
• Authorized Control Level
• Mandatory Control Level

• 200
• 150 - 200
• 100 - 150
• 70 - 100
• Under 70

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Historical RBC Results(Life, Property and Health)

• 1996 1997 1998 1999 2000
• No Action 3,799 3,740 3,707 3,870 3,953
• Company 59 54 54 84 92
• Regulatory 22 14 31 64
  67
• Authorized 11 8 22 23
  28
• Mandatory 31 27 43 46
  53
• Total 3,922 3,843 3,857 4,087 4,193
• (Life - 1993 Property - 1994 Health - 1998)

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Life RBC - RBC Requirement Percentage After
Covariance

• Asset Risk-Affiliate (C0)
• Asset Risk-All Other (C1)
• Insurance Risk (C2)
• Interest Rate Risk (C3a)
• Health Credit Risk (C3b)
• Total (C3) Risk
• Business Risk-Prem/Liab (C4a)
• Business Risk-Health (C4b)
• Total (C4) Risk
• RBC After Covariance
• Authorized Control Level RBC

• 22.0 billion 23
• 51.1 billion 53
• 19.1 billion 20
• 10.9 billion 11
• 32.0 million lt1
• 10.9 billion 11
• 3.7 billion 4
• 533.6 million lt1
• 4.3 billion 4
• 96.1 billion 100
• 48.0 billion

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NAIC Accreditation Base - LineLaws and
Regulations

• Key standards include
• 1. Examination Authority
• 2. Corrective Action
• 3. Risked Based Capital
• 4. Reinsurance
• 5. Investments
• 6. Reserves
• 7. Receiverships
• 8. Guaranty Funds
• 9. Accounting Practices

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Risk Assessment Working Group

• Recognition of new financial services
  marketplace rapid product innovation,
  convergence among the sectors, global
  competition, role of technology
• Need for a forward-looking perspective
  responsive to the specific risk exposures of a
  companys operations

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General Goals

• To create a framework for identifying and
  assessing risk exposures
• Categorize risks
• Analyze and evaluate risk exposures, both
  inherent and control risks
• Document results in a manner useful in focusing
  regulatory oversight
• Produce a type of risk profile or matrix for each
  company

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General Goals (continued)

• To make more effective current approaches to
  on-site examinations and on-going financial
  analysis by targeting resources to material risk
  exposures
• To encourage insurers to establish effective risk
  management systems

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Challenging Assumptions

• Regulators reliance on internal company
  processes to identify, evaluate, and manage the
  risks. Has top management the ability to
  circumvent internal controls?
• Increased reliance on work of outside auditors